All Financial Wisdom

Futures: Leverage, the “Danger” of Futures

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The fact that at the time of buying/selling a future, you only have to deposit a percentage of the nominal of the transaction as collateral is what allows for the possibility of leveraging with futures. This leverage, when not controlled, could be the cause of the large losses that can be incurred when trading futures, which is why they are considered to be dangerous investment instruments.

But this leverage is fully controllable by every investor, so no one runs more risks than you want. Futures are not dangerous/but rather, it’s the investors that trade futures that are dangerous 😉

Suppose that the futures on a bushel of wheat are quoted at $15.10 so that the nominal 1 futures contract (1 contract = 100 shares) on the wheat shares is $1,510 (15,10 x 100 = 1,510). If an investor has $1,510 in cash and buys 1 futures contract on the wheat, he’s running exactly the same risk as if he bought 100 shares of the wheat. No more no less.

For 1 contract, the broker would ask for guarantees of $226.50 and the rest of the money (1,510 – 226.50 = $1,283.50) could be placed in a deposit for 1 day. The risk is perfectly controlled and is exactly the same as a normal purchase of the wheat.

Leverage consists of buying futures contracts for a nominal amount greater than the amount of money that we actually have. In this example, the investor would have enough money to buy 6 futures contracts on the wheat, as they would demand a total of $1,359 (226,50 x 6 = 1,359) as collateral and still have a “leftover” of $151 (1,510 – 1.359 = 151). But in this case, he is running a very high risk, since he’s investing as if he had $9,060 (6 x 100 x 15,10 = 9,060) instead of the 1,510.

If the wheat future rises to $17.60, a profit of $1,500 will have been obtained (17.60 – 15.10 = 2.50, 2.50 x 6 x 100 = 1,500). The return obtained on the $1,510 that we really have is almost 100%. If we had only bought 1 contract the benefit, would have been the same as if we had bought 100 shares; 2.50 x 1 x 100 = $250.

The problem occurs if the future falls, for example to $12.6. In that case, the loss will be $1,500 (15,10 – 12,60 = 2,50, 2,50 x 6 x 100 = 1,500), practically 100% of our capital. Losses that would be caused by the investor’s imprudence, not by the futures themselves. The broker and the market in which the futures are traded would force us to close the position at that moment, regardless whether the price of wheat begins to rise afterwards. We would have no chance to recover our money.

Leverage is something that can be controlled. In the previous example, a leverage of 6 (9,060 / 1,510 = 6) was used, but lower leverage can also be used (for example 3:1, 2:1). The lower the leverage, the lower the risk. A leverage of 1 has a risk exactly the same as the purchase of normal stock.

As we have seen here the risk of a futures buyer is perfectly delimited, but the risk of the seller is different and in theory it is unlimited.

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