Futures Margins Explained

Leverage refers to the practice of applying small amounts of margin capital to purchase or control larger blocks of an asset for the purpose of magnifying the potential return on investment.




Traditional investors are accustomed to thinking of margin as an interest-bearing loan from their brokerage firm. In the futures industry, margin is not a loan but a cash deposit--a good faith bond whereby the customer places on deposit the required cash to indicate a willingness and ability to perform on the futures contract in the event that the position is not offset. Unlike stock margin accounts, future's margin is not subject to interest charges.





The Mathematics of Leverage



As a futures contract rises or falls, the unit price of movement is amplified by the degree of leverage inherent in the contract. To understand how an investor can potentially achieve higher returns due to leverage review the following example.



Example:
A futures investor is buying (1) Corn contract at an entry price of $2.00 and selling the contract at an exit price of $2.10. The inherent leverage in a corn contract produces a return of 83% on the trade. Here is how it works.



Contract Size Price Margin Price Change Change

1 Corn Contract 5,000 Bushels 2.00 $600 10 cents $50 per point





In this hypothetical example, the futures investor deposits $600 in initial margin funds to control a $10,000 contract of corn at the current price of $2.00. If the price moves up 10 cents the inherent leverage will produce high net profit returns.



Buy at 2.00

Sell at 2.10

Profit 10 points x $50 = $500

Net Profit (before commissions) of 500 ÷ 600 (margin) = 83% return



Investors must remember, leverage is a double-edge sword. Losses can also be amplified to the same degree as gains. As leverage is increased so is risk. The same price movement in the opposite direction would produce a comparable loss. Therefore it is critical that alternative investors understand risk, before implementing a futures trading strategy.
 
Futures trading involves substantial risk and are not suitable for all investors