Futures trading has several significant advantages over trading with conventional underlying assets such as stocks. The first one is that futures trading inherently includes leverage. The term leverage means that you can control large amounts of assets (corn, gold, and others) via only a low marginal amount. Let’s explain this principle on an example.
At the time of writing this chapter, crude oil futures contract with expiration in September 2013 cost $ 106 per barrel. Margin for one crude oil futures contract was $ 4,500. The amount of margin for each underlying asset is determined by the exchange.
In this model example we buy one crude oil futures contract. The standardised size of one oil futures contract is 1,000 barrels. In order to be able to buy one oil futures contract we need to have at least $ 4,500 on our trading account. In fact, you should have much larger amount at your disposal because if the price of oil went in the opposite direction than your business strategy you would begin to lose and you would receive a “margin call”. Margin call is a notice from your broker that you must add funds to your account. Margin call is sent in a situation when your account balance falls below a certain limit laid down by the broker. If you ignore the notice, the broker closes your positions at his discretion (you cannot influence which particular positions will be closed and it is therefore possible that the broker closes just the most profitable ones).
So let´s rather imagine that we have at least $ 20,000 on our account. If we buy a futures contract for oil, our broker blocks the margin (deposit) of $ 4,500 on our account. But you do not have to worry that you would lose this money. As we have already explained before, the principle of trading with futures contracts is that we agree upon delivery time and cost of a future contract in the moment of its purchase, while the financial settlement and the commodity´s physical delivery takes place on an agreed date in the future. Therefore, when buying a futures contract we do not pay any money, only the margin is blocked on our account. When we sell the contract, the margin will be unblocked and the amount of $ 4,500 will appear on our account again. At the same time, the achieved profit will be credited or the suffered loss will be deducted.
So we bought one oil futures contract for $ 106 and thus we have an open trading position and a margin was blocked on our account. The actual situation on our account with the initial balance of $ 20,000 is: $ 20,000 – $ 4,500 (blocked margin) = $ 15,500,
i.e. we bought one futures contract for oil for $ 4,500 margin. We have already said one futures contract consists of 1,000 barrels of oil. On the futures exchange´s website you can find the information that the value of a one-point price movement of a barrel of oil is $ 1. Our futures contract, which we bought for $ 106 and with $ 4,500 of blocked margin, has a total value of 1,000 barrels * $ 106 = $ 106,000.
And that is the point! We needed only $ 4,500 to open a position with the value of $ 106,000! Do you see the difference? Our leverage is therefore $ 4,500 / $ 106,000 = 1:23.55. Thanks to the leverage the appreciation potential is huge. Let’s explain why.
Imagine that after some time after buying of our oil futures contract its value rises by 3% to $ 109.18 per barrel. We decide to sell our futures at this price. The actual value of a futures contract containing 1,000 barrels of oil is $ 109.18 * 1,000 = $ 109,180, i.e. we gained $ 109,180 – $ 106,000 = $ 3,180 profit. Needless to say that a 3% price increase may be a matter of a few months (or even a week) in commodity markets. Regarding our margin $ 4,500, you can see that we managed to achieve a 70% profit. Yet objectively, we could also lose 70% of the margin if the price fell by 3% and thus went against the direction of our business strategy.
To avoid such losses we have many risk management instruments available, as will be explained in later chapters. For now you should only remember that margin is an amount that is blocked on your account when you open a trading position. When you close your position and exit the market, your broker will unblock the margin and the funds will become available again. Therefore, you need to be careful and do not open too many positions. Each newly opened commodity futures contract means blocking of a margin and a lower balance of your account until the position is closed. Thus be careful about the margin. Margin Call should ideally remain a theoretical concept for you, a hypothetical situation in which you will never get. This is because after margin call your broker would release the blocked margins by closing even those positions which should remain open according to your business plan. You should therefore manage your positions in such a way that margin calls remain only something which you hear about from other traders or read about in books like this.
Remember that you will start as novices and that in trading applies that (with three exclamation marks): Who wants more ends up with nothing. You should pay attention to the very essentials and have realistic objectives and plans. If you think that you open an account with a few thousand dollars and become fabulously rich, then you should rather bet lotto. There is the same 99.9% probability that you will lose your money and it will cost you no effort and time. Of course, you can generate very nice profits with your few-thousand dollar account, even tens of percent a year, but you always have to have the risk under control and you must keep sufficient reserves on your accounts. The spectre of margin is often more real than the beginners like you are willing to admit.