Leverage and Futures
By Lind-Waldock
APR 2007
You've probably heard that leverage is one characteristic of futures that makes them unique from other investment vehicles. It can make futures more capital-efficient, too. While leverage can be a positive thing for you as an investor, it can be a negative too. Let's take a look at what leverage means.
Leverage implies the use of borrowed capital (margin) to finance a larger investment with a smaller amount of funds. If you've bought real estate, you're probably already familiar with how leverage works. Say you buy a $300,000 home with 20 percent down ($60,000). In five years, your home might have appreciated to $360,000. That's a $60,000 gain, or a 100 percent return on your initial $60,000 down payment.
Leverage can be a boon to investors on the winning side of the market, as gains can be magnified. On the other hand, so can losses if you are on the losing side.
Let's see how a futures and a stock market investment can differ when you add leverage into the equation. Futures of course are traded in contracts. In the stock market, your "contract" value is the number of shares times the price of the stock. For example, 1,000 shares of XYZ times $42 a share equals $42,000. So your "contract" size would be $42,000. If the price of the stock increases 10 percent, to $46.20 a share—that's what your total investment has likewise earned, 10 percent, or $46,200.
In futures, you often have to commit no more than 10 percent of the contract value in order to take a long or short position. For example, if a CME E-mini S&P 500 contract is worth $50,000 you may need no more than $5,000 to buy or sell the contract. In contrast to the stock market example, if you buy and the contract's value increases 10 percent, to $55,000, then your initial investment of $5,000 will have increased 100 percent, to $10,000.
Leverage can be equally potent when a position is going against you. Let's say that you took the same action as before—you spent $5,000 to take a long position. But, now the contract's value falls 10 percent, to $45,000. Now, you are essentially wiped out. Your $5,000 is gone. And unless you get out of the position with an offsetting sale when your maintenance margin level is violated, you'll be obligated to put up even more money if the market keeps moving against you.
While leverage can be a double-edged sword depending on market conditions, leverage does allow you to use excess funds for other purposes, including investing in other assets. In other words, you get capital efficiency. In the event the market is moving the way you want it to, your returns will likewise be greater than with a similar cash-equity investment, such as an exchange-traded fund (ETF). Of course, as outlined, losses can be greater in futures if the market moves against you—and you could potentially lose more than you initially invested if you are not careful.
Leverage is just one of many unique characteristics of futures. Download our Free Why Futures Now Guide and find out more.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
© 2007 Lind-Waldock, a division of MF Global, Ltd. All Rights Reserved.
