Futures Leverage, a Double-Edged Sword
The basic definition of leverage is to use a financial tool or instrument to maximums the advantage of a speculative undertaking. A prominent example of investing on leverage is the purchase of a home with a minimal down payment. Although the buyer of the home is entitled to any price appreciation of the home, he is also subject to the pain of declining home values. Yet, his profits and losses in regard to the home value are exaggerated on a percentage basis because of a lack of true equity in the home. Simply put, if a home buyer puts $20,000 toward a down payment for a $200,000 home, a 10% increase in the value of the home to $220,000 results in a 100% return to the home owner but a decline to $180,000 results in a 100% loss! It is easy to see how leverage can be either a very expensive, or very lucrative, venture.
Despite the casual approach to leverage in the commodity markets, it is even more treacherous than that of real estate. After all, even after the 2006 down turn, real estate volatility pales in comparison to most commodities. The purpose of this article isn’t to deter you from trading futures, it is to help you to understand the difference between responsible leveraged speculation, and treating the futures markets as a roulette wheel.
Just how much leverage is built into the commodity markets?
It is easy to get sucked into the mindset that commodity market leverage is “normal”, but I can assure you it isn’t. Have you ever tried trading with your stock broker on leverage? He will likely require that you have at least $50,000 to $100,000 in your trading account. Further, he will charge you interest for the luxury of borrowing brokerage firm shares to short. Most good futures brokers don’t have minimum funding requirements; if they do, they are generally $5,000 to $10,000.
The luxury of cheap and easy leverage is primarily extended to commodity traders via the exchanges, but brokers have a say in how much leverage their day trading clients are granted. Naturally, their propensity to promote high volume trading, which translates into higher commission charges, encourages brokers to lower required margin rates do day traders. This exponentially increases trading leverage to a point in which it is nearly impossible to make money. Of course, they don’t tell you this…but they know. With that said, having access to convenient leverage is a luxury, not a right; don’t abuse it. Traders often assume leverage is owed to them, but it is something that can only be earned. Just like a bank vets a borrower before granting a loan, a futures broker won’t grant access to futures market leverage before confirming the client is “good for it”.
