Leverage is Great - When Used Responsibly
Leverage is Great - When Used Responsibly
The first thought conjured up when laypeople hear the words futures trading is that it's pretty much just another form of gambling. They've all heard some anecdote of a distant relative that lost a lot of money trading pork bellies, or the story of how the former First Lady turned a mere $1000 initial deposit into a staggering sum of $100,000 in just 10 months by trading cattle futures. Some find these stories farfetched, and generally think this would not be possible unless there were something untoward at work.
The reality is that it's possible to take a relatively small sum of money and grow it exponentially in the futures market. That's due to the leverage afforded in these markets. Leverage, when used properly can amplify gains, but can also work to magnify losses.
Leverage, in my view, is a beautiful thing, when used properly, of course. How many rich people do you know who got that way using their own money? Not many. But just like anything else, too much of a good thing can be disastrous. We know this all too well these days as the reckless overuse of leverage was almost responsible for a total financial meltdown 3 years ago.
In the futures market, the leverage is approximately ten to one for most contracts. This is quite tame in comparison to the spot Forex market which is leveraged fifty to one. As an example, the S&P E-mini contract has a notional value of $50 times the contract, so at the current level of 1350, that is $67,500. The full margin currently (amount needed to hold a contract overnight) is $5000. The intraday rate is 25% of that, or $1250. At first blush, it seems dangerous to have that amount of leverage, but if we look at it from an opportunistic perspective, it looks much different.
Here's an example comparing the E-mini Russell futures contract versus the corresponding ETF (exchange traded fund). First, the contract specifics for the E-mini Russell 2000 are as follows:
Full margin (for overnight trading) is $3500.00 (intraday $1000)
$10 minimum fluctuation ($100 per point)
Notional value at the current index value of 850 is $85000 ($100 x the index)
ETF requirements for the same movement:
1000 shares
Full margin $42,500 (intraday $21,250)
In doing some quick math, we can conclude that the return on investment for the futures contract pales in comparison. A one point profit (say a move from 84 to 85 in the EFT) would net $1000, or roughly a 4.5% return. Whereas the futures return on the same move (10 points in the futures contract) is equal to a bit over 30% return. Incidentally, because these are smaller companies, the index tends to be more volatile and thus, this type of movement is very common in the Russell 2000 index.
I know some of you are thinking that for those type of returns, one must have to assume a tremendous amount of risk. Actually, that's the beauty of trading futures; you don't have to take as much risk as might be suspected. That's because we only take trades with very low risk and high reward. This requires a viable strategy, and the discipline to follow it. A big word of caution: If you possess neither of the aforementioned, then futures trading is most definitely not for you. However, by gaining the proper knowledge, these can be honed.
I don't expect everyone reading this piece to go out and open a futures account tomorrow; however, for those of you that have a limited amount of capital, or plan on trading as a way to generate income, this is definitely worth looking into.
To conclude, leverage can be a tremendous asset if used smartly. Think about your first home, if the bank hadn't been there to provide you with 90 or 80% of the financing (leverage), there would have been a slim chance to acquire it and all the benefits that you have enjoyed, provided you bought at the right time. The same can be said about other leveraged investments such as futures. So check out a class or get further information on the futures market to get started.
Until next time, I hope everyone has a great week - Gabe Velazquez
"About Gabe Velazquez
Gabe got his start in the markets as a broker trainee for Paine Webber, a mere 3 months before the market crash of 1987. That experience brought to light the importance risk management plays in trading and investing. In fact, it's greatly influenced the way he trades today. He spent 15 years as a stock and commodities broker, conducting technical analysis seminars through-out Southern California. After many years of managing other people's money, Gabe now concentrates full time on trading his own portfolio and teaching. He currently holds a series 7, 63, 9 and 10 (securities and options principals license.)
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