Leverage – Futures versus Equities

What makes trading Futures different than trading equities?

Futures markets provide leverage not fundamentally inherent in other investment vehicles, such as stock or mutual fund trading. It is critical to understand the implications of futures market leverage. Simple examples illustrate how leverage allows the trader to profit in futures trading with a substantially smaller initial investment than would be required for an equity trade. The next section describes contract specifications and leverage in more detail.

There are other details that differentiate stock trading from futures trading, however we will not examine them here. We are concerned with the primary difference, which is leverage.

Contract Specifications and Leverage

Every futures contract has specific components that define the contract and influence the amount of leverage for the contract. You should understand as much about a contract’s specifications as possible.

Let’s look at Corn futures as an example. Contract spec information includes:

The contract size = 5,000 bushels per one contract.

The contract trades in ¼ cent minimum increments.

¼ cent = $12.50 / $.01 = $50

Initial Margin is set by the exchanges. Initial margin and can be modified by the brokerage firm if it so desire varies. For Corn, initial margin is typically between $800 and $1200 per contract. Maintenance Margin is typically between $500 and $800. Don’t worry too much about terminology for now. You can consult our Glossary of Terms for more information about a given term.

Furthering our example of leverage, assume you receive a signal that indicates corn will move from $7.60 ½ to $7.72 ½. For this example, let’s assume Initial Margin = $1000/contract. For one contract, you will invest $1000 on this trade. If you are correct in your market prediction, you will make $.12, which is equal to $600. The math is computed as follows:

The purchase price is $7.60 ½ – at this price, through leverage in the futures contract, you are essentially “controlling” $7.60 1/2 * 5000 = $38,025 worth of corn. That’s a lot of corn to control with only a $1000 initial investment!

You offset your futures contract by selling it at $7.72 ½ – $7.72 ½ * 5000 = $38,625. Your profit is $38,625 – $38,025 = $600.

In this example, you invested $1000 and made $600. On one trade, your return = $600 profit/$1000 margin = 60%. Not bad. Such is the effect of leveraged trading.

Now let’s look at a typical stock trade. Suppose you are trading Microsoft stock and want to make the same $600 profit you made on your Corn futures trade.

Assume Microsoft is trading at $30 / share and you predict a $1 upward move in price. Without leverage (i.e. you are not trading stock on margin), you would need to purchase 600 shares, at $30/share. If the stock were to rise $1.00 to $31/share, you would make $600.

However, let’s look at the required initial investment – 600 shares at $30/share = $18,000. If the stock moves to $31, you sell it at $18,600. You make $600, net profit. However your return on investment plummets. It is computed as: $600 profit / $18,000 initial investment = .03%

Compare our 60% return on our futures trade versus 3% return on our stock trade. Of course leverage works both ways – you can make tremendous profits, however the risk of loss is also great. However in the section of this site that recommends how to trade futures, we will describe ways to limit our losses if we are incorrect in our trading decisions.