Futures: Disadvantages of trading in futures:
High risk of loss - Before
becoming too excited about the substantial returns possible from commodity
trading, it is a good idea to take a long, sober look at the risks. Reward and
risk are always related. It is unrealistic to expect to be able to earn
above-average investment returns without taking above-average risks as well.
Commodity trading has the reputation of being a highly risky endeavor. It is
true that a high percentage of traders eventually lose money. Many people have
lost substantial sums. Leverage is a double edge sword, it can either make you
rich or make you lose your shirt and more.
However, commodity trading's
reputation as a highly risky activity is somewhat undeserved. Think of yourself
walking into a gambling casino in Las Vegas or Atlantic City. You decide to play
roulette. The table has a $5 minimum bet and a $5,000 limit, which happens to be
your total bankroll. If you place a $5,000 bet on red, you should not be
surprised if you immediately lost your $5,000. On the other hand, if you made
only $5 bets, you could play for a long time and probably not lose very much at
all.
Commodity trading is the same in the
sense that the individual is the one who decides how he wants to operate. He can
make large bets or small ones. One can trade commodities carefully and risk as
little as $100 or $200 on a trade. You could trade a long time this way and only
lose a few thousand dollars. However, most people are not that patient. The
unfortunates who lose big are those who can't control themselves. They take big
risks in an attempt to get rich quick.
Margin Call - To understand
margin call, lets take an example. Let's assume that you bought a house for
$100,000 with $10,000 down payment and a year from now, your bank that has your
mortgage called you and said "your house is now worth only $80,000, we need you
to sent in $20,000 by tomorrow or we'll sell the house". Of course that don't
happen when you buy a house. But it often does happen in a futures market.
To use the example above, $10,000 is your initial margin and $20,000 is the
amount of margin call you must come up within a short time (usually 1 to 2 days)
or your broker has the right to liquidate your futures positions. Remember that
futures market are "marked for market" which means profit and losses are
calculated daily. Of course on the other side, if the price of the house went up
to $120,000, you can't go to the bank and say give me that $20,000. In the
futures market, you can call your broker and say "sent me the $20,000" and
they'll gladly sent it to you.
In the futures market, rather than
providing a down payment like on a house, the initial margin
required to buy or sell a futures contract is solely a deposit of good faith
money that can be drawn on by your brokerage firm to cover losses that you may
incur in the course of futures trading. It is much like money held in an escrow
account. Minimum or initial margin requirements for a particular futures
contract at a particular time are set by the exchange on which the contract is
traded. They are typically about five percent of the current value of the
futures contract. Exchanges continuously monitor market conditions and risks
and, as necessary, raise or reduce their margin requirements. Individual
brokerage firms may require higher margin amounts from their customers than the
exchange-set minimums.
If and when the funds remaining
available in your margin account are reduced by losses to below a certain
level--known as the maintenance margin requirement--your broker
will require that you deposit additional funds to bring the account back to the
level of the initial margin. Or, you may also be asked for additional margin if
the exchange or your brokerage firm raises its margin requirements. Requests for
additional margin are known as margin calls. Assume, for example,
that the initial margin needed to buy or sell a particular futures contract is
$5,000 and that the maintenance margin requirement is $4,000. Should losses on
open positions reduce the funds remaining in your trading account to, say,
$3,000 (an amount less than the maintenance requirement), you will receive a
margin call for the $2,000 needed to restore your account to $5,000. Most people
can not meet the dreaded margin calls and the positions are liquidated at a
loss.
It is very important that before
trading in futures contracts, be sure you understand the brokerage firm's Margin
Agreement and know how and when the firm expects margin calls to be met. Some
firms may require only that you mail a personal check. Others may insist you
wire transfer funds from your bank or provide same-day or next-day delivery of a
certified or cashier's check. If margin calls are not met in the prescribed time
and form, the firm can protect itself by liquidating your open positions at the
available market price (possibly resulting in an unsecured loss for which you
would be liable).
Next==>>
Characteristics of
Futures Markets
Heroes
are heroic because they, despite their weaknesses
-- and sometimes because
of them -- do great things.
-- Benjamin Hoff (Excerpt from The Te of Piglet)
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