Get a Grip on Commodity Market Leverage

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 futures 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”. 

I often here traders casually mention their intention to buy or sell 10 e-mini S&P futures as if it is a minor position.  However, I wonder if they have ever taken the time to do the math to determine just how much risk exposure such a trade comes with.  Let’s assume the e-mini S&P 500 is valued at 2,000; each point is worth $50, so the notional value of the contract is $100,000 (2,000 x $50).  Accordingly, a trader that enters an order to buy or sell 10 e-mini futures contracts is essentially subject to the profits and losses of roughly $1,000,000.  The exchange requires about $5,000 to hold a single e-mini S&P contract overnight, which equates to about 5% of the underlying asset.  Thus, a futures trader needs only $50,000 in a trading account to buy and hold $1,000,000 worth of the S&P 500.  Even more astounding, some brokerage firms offer day trading margin in the e-mini S&P 500 as low as $500, which translates into a margin down payment equivalent to half a percent.  We all know what happened to home owners that put a down payment of less than 1% toward their mortgage.   There are day traders out there that think little of trading 10 e-mini S&P 500s in a $5,000 account simply because their brokerage firm allows them to put the trade on.  Nevertheless, some quick math reveals that the odds of success when trading $1,000,000 worth of securities in a $5,000 are dire.

Leverage is in the hands of the Trader

Exchanges and brokerage firms generate revenue each time a futures or options trade is executed.  For this reason, as well as others, they extend low margin rates with high levels of leverage to encourage trading volume.  However, just because such leverage is available, doesn’t mean it is appropriate to use it.  When it comes to leverage, less is more. 

It is possible to greatly reduce leverage in three ways:

  1. Over-fund the trading account – The most effective way to lower leverage, and increase the odds of trading success, is by simply holding more money in the account than is required in margin.  For instance, if the e-mini S&P margin is $5,000 and the contract value is $100,000, a trader can completely eliminate leverage by trading a one lot in a $100,000 account.  The same trader could reduce the leverage from the exchanges 20 to 1, to a more comfortable 10 to 1 by trading a one lot in a $50,000 account, and so on.
  2. Trade smaller contracts – If you don’t have the funds available to fully fund a futures trading account to eliminate the margin, you are not alone.  Yet, you can efficiently reduce leverage in smaller accounts by trading futures contract with small sizes, such as e-micro currencies and metals.
  3. Sell antagonistic options – Many stock traders love the added income provided by a covered call strategy, but for some reason the practice isn’t as popular in futures trading.  Perhaps it should be.  The leverage that comes with futures trading make selling deep out-of-the-money calls against a long futures strategy a relatively dangerous strategy.  This is because a price decline will result in much bigger futures contract losses, than short call gains.  Accordingly, in futures it makes more sense to sell closer-to-the-money calls against a long futures contract.   The same strategy can be applied to a short futures contract, but the trader would be selling a nearby put option. The practice brings in a healthy amount of premium to cushion the blow of any adverse futures market move, and does wonders for taking the stress away from trading.

Don’t Under-Estimate Leverage

I know leverage abuse and risk aren’t popular topics amongst traders because most of them overdo it.  It is human nature to indulge when we can, knowing we shouldn’t.  If you ever want a reminder of this very powerful human nature, go to a high quality Las Vegas buffet.   Knowing better we still can’t seem to avoid pushing our capacity to the limits of reason.

I would argue the primary cause of retail trader losses is simply being overleveraged.  This is because leverage reduces the room for error, and enhances emotional turmoil felt by every tick the market makes.  When determining appropriate levels of leverage always err on the side of caution.

Carley Garner is the Senior Strategist for DeCarley Trading, a division of Zaner, where she also works as a broker.  She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com.  Her books, "A Trader's First Book on Commodities," "Currency Trading in the FOREX and Futures Markets," and "Commodity Options," were published by FT Press.

 

 

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