Leverage Makes Futures Viable
Futures contracts are purchased on margin. Buying futures contracts on margin differs materially from buying stock on margin. In the stock market (which is a cash market), when a stock is bought on margin, the purchase can be paid part in cash, called the margin, and in part by a loan, on which interest must be paid. Usually, the loan is made by the brokerage firm effecting the purchase. In contrast, the margin for futures contracts is a performance bond or earnest money. It is usually only 5%–10% of the value of the contract. The margin is put up in good faith, indicating the buyer's or seller's willingness to pay or deliver the entire amount, if the contract is held until delivery.
Low margin requirements make it possible to hedge even small quantities of commodities; high margins would be prohibitive. If hedgers, who handle large quantities, would be forced to deposit 100% of the value of the hedged commodity, they would be handicapped severely. They would lose one of the advantages of the futures market and face some of the problems that were common before the futures markets came into being. Specifically, hedgers would face the onerous and expensive task of borrowing money to finance their hedges. With the help of futures markets, producers may borrow money against their hedged position. They may use this money to help finance operating expenses that are incurred during the year. Some of the borrowed money may also be used to cover the cost of hedging. In short, the small margin required to buy futures contracts reduces the amount of capital needed to hedge. Capital is set free for use in other areas.
The small amount of capital needed to buy futures contracts also makes it attractive for speculators to participate. Speculators are vital to the market. They are willing to carry the risk which hedgers would like to avoid.
speculating in futures contracts could not compete with other investments.
The prices of most commodities move only a few cents a day. In fact, changes in the prices of many commodities are measured in fractions of a penny. If 100% of contract value were needed to buy or sell commodities, the rate of return on most commodities would be extremely small. In the stock market, where changes in prices are quoted in dollars and fractions thereof, the rate of return can be significant, even when depositing 100% of the purchase price.
An example may illustrate the case. In the stock market, an investor who buys 500 shares of a stock selling at $60 a share will deposit $30,000 to purchase the stock. His investment goal is to hold the stock for a $10/share increase. If he meets his goal, he will have achieved a 16.67% return on investment (before commissions). On the other hand, a futures trader buying a contract for 5,000 bushels of corn at $6/bushel will have $30,000 at risk, but will only be required to deposit $3,000. His investment goal is to hold the futures contract for an increase in corn prices of 10¢/bu. If he achieves this goal, his return on investment, before commissions, will also be 16.67%. If he were required to deposit the entire contract value ($30,000), the return from his expected price increase would be only 1.67%—one-tenth the return he could get by investing the same $30,000 in the $60 stock above!
The small margin needed to trade commodity futures provides the investor with leverage that may generate an acceptable rate of return. Leverage is the extent to which a trader can effect, by the use of a margin, changes in return on the investment greater than the changes in price. It is this leverage that attracts the investors needed to give liquidity to futures markets. It is very attractive, but it also makes futures trading rather risky.
Low margin requirements tempt some traders to enter into more contracts than they can cover financially, if the market should go against them. These traders are flirting with disaster; they would do better limiting their futures commitments to the capital they can command for outright purchases.
A key element of effective money management is knowledge of the market. Many traders who need to hedge do not take the time to carefully observe the markets to take advantage of opportunities. A good broker may be helpful providing information and advice, which makes the choice of a broker rather important. A broker should bring knowledge and information, and impart discipline to trading. Discipline and self-restraint are essential traits, yet they are difficult to acquire. Discipline is the basis of wise management; it prevents wishful thinking and reckless overextension. A disciplined trader develops an effective and sensible trading plan that sets limits to his commitment and maintains control over his actual trading. Traders who lack this self-control give the industry the reputation for being unpredictable and volatile.
A hedging plan should reflect the degree of risk a trader is willing and able to bear. It should build on an estimate of the risk that needs to be hedged and then assume a futures position that does not exceed the cash position. A trader who goes beyond the hedge and enters futures contracts in excess of his cash position actually enters the realm of speculation. In short, knowledge, discipline and a trading plan all contribute to good money management and successful futures trading. And yet, the best money management and the best broker cannot remove all the risk inherent in futures trading. The future is always uncertain and subject to the unforeseeable.
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