This monthly educational series features the basic workings of the futures and options markets and how they can be utilized to help farmers with risk management.
THE FUTURES MARKETS are a prime example when discussing the use of leverage.
In brief, leverage is a method to increase returns on your investment by using only five to 10 per cent of the total investment value to secure a position. It is said that in the futures market, more than any other form of investment, price changes are highly leveraged — meaning a small change in a futures price can translate into a huge gain or loss.
A more common leveraged investment that most people are aware of today would be their home. To buy a house that has a value of $400,000 one might put as little as 10 per cent ($40,000) down (margin) and finance the balance with a mortgage. If your home appreciates five per cent in the next year, you would realize a $20,000 ($400,000 X 0.05 = $20,000) profit on the $400,000. Because you only deposited $40,000 on the home, your actual rate of return would be 50 per cent ($20,000 / $40,000 x 100 = 50%). This is the power of leverage.
Futures positions are highly leveraged because the margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question. The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. For an initial margin of $3,000, you may be able to enter into a long position in a futures contract for 5,000 bushels of wheat valued at $30,000, which would be considered a highly leveraged investment.
Highly leveraged investments can produce two results: great profits or great losses.
As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. For example, say that in anticipation of a rise in wheat prices you buy a futures contract for 5,000 bushels with a margin deposit of $3,000. The value of the wheat contract when you purchase it is $6 per bushel or $30,000 ($6 x 5,000 bushels). If wheat moves up 20 cents per bushel to $6.20 you have made a profit of $1,000 (.20 x 5,000). Based on the value of the contract, that is a 3.33 per cent return on the $30,000 ($1,000/$30,000 x 100), but since you only put up the required margin of $3,000 the return on your investment is actually 33.3 percent (1,000 / 3,000 x 100) or 10 times the profit.
On the other hand, if the wheat declined 20 cents per bushel, it would result in a monetary loss of the same math as above — a loss of $1,000 or 33.3 per cent of your actual investment. A huge percentage when compared to the initial margin deposit made to obtain the contract.
My advice to investors is to use leverage to your advantage but not to abuse it. I feel that a realistic amount of margin to secure a position would be 30 per cent. This way you can still benefit from the margin without being squeezed out of the market for shortage of working capital.
This is one example of leverage but by no means the only one. We will discuss what I refer to as super leverage in a future lesson. •
Marty Hibbs is a 25 year veteran futures trader, analyst, and portfolio manager. Hibbs was a regular guest analyst on BNN for four years. He is currently a grain merchandiser with Grain Farmers of Ontario.
DISCLAIMER: This information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by the author, by Grain Farmers of Ontario, or by any other person as to its accuracy, completeness or correctness and Grain Farmers of Ontario accepts no liability whatsoever for any loss arising from any use of same.
Margin: Cash or equivalent posted as guarantee of fulfillment of a futures contract (not a down payment).
Initial margin: In the futures market, this refers to the initial deposit required in an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses. This generally represents about five to 15 per cent of the contract value. This is calculated daily.
Maintenance margin: The minimum amount of equity that must be maintained for all open positions in a margin account. This is usually represented as cash excess which can be used to secure losses on a day to day basis for all open positions in a futures account. Maintenance margins vary from broker to broker and are generally lower than initial margins once the position is open.
Margin call: Demand for additional funds or equivalent because of adverse price movements or some other contingency. •