|
To say that gains and losses in futures 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--and of how it can work to your advantage or
disadvantage--is crucial to an understanding of futures
trading.
As mentioned in the introduction, the 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. On a particular day, 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 futures contract, the greater the
leverage.
If you speculate in futures contracts and the price moves in
the direction you anticipated, high leverage can produce
large profits in relation to your initial margin.
Conversely, if prices move in the opposite direction, high
leverage can produce large losses in relation to your
initial margin. Leverage is a two-edged sword.
For example, 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 assume
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!
Said another way, while buying (or selling) a
futures contract provides exactly the same dollars
and cents profit potential as owning (or selling
short) the actual commodities or items covered by
the contract, low margin requirements 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
(at least emotionally) 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.
Next:
What is a Futures Contract?
|
