Arithmetic of Futures Trading

To say that gains and losses in commodity trading are the result of price changes is an accurate explanation but by no means a complete explanation. Perhaps more so than in any other form of speculation or investment, gains and losses in futures trading are highly leveraged. An understanding of leverage is crucial to an understanding of commodity trading.

Leverage of futures trading stems from the fact that only a relatively small amount of money, known as initial margin, is required to buy or sell a futures contract. For example, a margin deposit of only $1,000 might enable you to buy or sell a futures contract covering $25,000 worth of soybeans. Or for $10,000, you might be able to purchase a futures contract covering common stocks worth $260,000. The smaller the margin in relation to the value of the commodity contract, the greater the leverage.

If you speculate in commodities and the price moves in the direction you anticipated, the leverage could produce large profits in relation to your initial margin. If prices move in the opposite direction, this leverage can produce large losses in relation to your initial margin.

Assume that in anticipation of rising stock prices you buy one June S&P 500 stock index futures contract at a time when the June index is trading at 1000. And say your initial margin requirement is $10,000. Since the value of the futures contract is $250 times the index, each 1-point change in the index represents a $250 gain or loss. Thus, an increase in the index from 1000 to 1040 would double your $10,000 margin deposit and a decrease from 1000 to 960 would wipe it out. That's a 100% gain or loss as the result of only a 4% change in the stock index.

When buying or selling, a futures contract provides exactly the same dollars and cents profit potential as owning the actual commodity or items covered by the commodity contract. Low margin requirements can sharply increase the percentage profit or loss potential. For example, it can be one thing to have the value of your portfolio of common stocks decline from $100,000 to $96,000 (a 4% loss) but quite another to deposit $10,000 as margin for a futures contract and end up losing that much or more as the result of only a 4% price decline. Futures trading thus requires not only the necessary financial resources but also the necessary financial and emotional temperament.

 Closing Bell                      Commodity Futures Menu                      Commodity Trading 

Information is believed to be reliable and is provided 'as is' without warranty.