Futures: Characteristics of the Futures
Market
Given the nature of the futures market, the
calculation of profit and loss will be slightly different than on a normal
stock exchange. Let's take a look at the main concepts:
Margins
In the futures market, margin has a definition distinct from its definition
in the stock market, where margin is the use of borrowed money to purchase
securities. In the futures market, margin refers to the initial deposit of
“good faith” made into an account in order to enter into a futures contract.
This margin is referred to as good faith because it is this money that is
used to debit any day-to-day losses.
When you open a futures contract, the futures exchange will state a minimum
amount of money that you must deposit into your account. This original
deposit of money is called the initial margin. When your contract is
liquidated, you will be refunded the initial margin plus or minus any gains
or losses that occur over the span of the futures contract. In other words,
the amount in your margin account changes daily as the market fluctuates in
relation to your futures contract. The minimum-level margin is determined by
the futures exchange and is usually 5% to 10% of the futures contract. These
predetermined initial margin amounts are continuously under review: at times
of high market volatility, initial margin requirements can be raised.
The initial margin is the minimum amount required to enter into a new
futures contract, but the maintenance margin is the lowest amount an account
can reach before needing to be replenished. For example, if your margin
account drops to a certain level because of a series of daily losses,
brokers are required to make a margin call and request that you make an
additional deposit into your account to bring the margin back up to the
initial amount.
Let's say that you had to deposit an initial margin of $1,000 on a contract
and the maintenance margin level is $500. A series of losses dropped the
value of your account to $400. This would then prompt the broker to make a
margin call to you, requesting a deposit of at least an additional $600 to
bring the account back up to the initial margin level of $1,000.
Word to the wise: when a margin call is made, the funds usually have to be
delivered immediately. If they are not, the brokerage can have the right to
liquidate your position completely in order to make up for any losses it may
have incurred on your behalf.
Leverage: The Double-Edged Sword
In the futures market, leverage refers to having control over large cash
amounts of commodities with comparatively small levels of capital. In other
words, with a relatively small amount of cash, you can enter into a futures
contract that is worth much more than you initially have to pay (deposit
into your margin account). It is said that in the futures market, more than
any other form of investment, price changes are highly leveraged, meaning a
small change in a futures price can translate into a huge gain or loss.
Futures positions are highly leveraged because the initial margins that are
set by the exchanges are relatively small compared to the cash value of the
contracts in question (which is part of the reason why the futures market is
useful but also very risky). The smaller the margin in relation to the cash
value of the futures contract, the higher the leverage. So for an initial
margin of $5,000, you may be able to enter into a long position in a futures
contract for 30,000 pounds of coffee valued at $50,000, which would be
considered highly leveraged investments.
You already know that the futures market can be extremely risky, and
therefore not for the faint of heart. This should become more obvious once
you understand the arithmetic of leverage. Highly leveraged investments can
produce two results: great profits or even greater losses.
Due to leverage, if the price of the futures contract moves up even
slightly, the profit gain will be large in comparison to the initial margin.
However, if the price just inches downwards, that same high leverage will
yield huge losses in comparison to the initial margin deposit. For example,
say that in anticipation of a rise in stock prices across the board, you buy
a futures contract with a margin deposit of $10,000, for an index currently
standing at 1300. The value of the contract is worth $250 times the index
(e.g. $250 x 1300 = $325,000), meaning that for every point gain or loss,
$250 will be gained or lost.
If after a couple of months, the index realized a gain of 5%, this would
mean the index gained 65 points to stand at 1365. In terms of money, this
would mean that you as an investor earned a profit of $16,250 (65 points x
$250); a profit of 162%!
On the other hand, if the index declined 5%, it would result in a monetary
loss of $16,250--a huge amount compared to the initial margin deposit made
to obtain the contract. This means you still have to pay $6,250 out of your
pocket to cover your losses. The fact that a small change of 5% to the index
could result in such a large profit or loss to the investor (sometimes even
more than the initial investment made) is the risky arithmetic of leverage.
Consequently, while the value of a commodity or a financial instrument may
not exhibit very much price volatility, the same percentage gains and losses
are much more dramatic in futures contracts due to low margins and high
leverage.
Next ==>>
Details on
Future Contracts
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