One of the reasons so many people are attracted to trading commodity futures and options over other financial instruments such as stocks is that you can get much higher leverage. While many investors have heard of the word leverage, few have a clue about what leverage really is, how it works, and how it can directly impact their bottom line.

In the finance world, leverage has many different meanings. The basic idea is to use a small sum of money now with the goal of acquiring a greater amount of money later. Imagine a teeter-totter in a children’s playground. A small child can lift an adult into the air, provided the pivot-point under the horizontal plank is placed in the right spot. For around 5 – 10 percent of the price of a commodity, an investor can “control” – even though he doesn’t own – 100 percent of a quantity of the good. That’s leverage.

The 5 – 10 percent figure is known as “margin,” and in the futures world, this is known also as a performance bond, or “good faith” deposit on the full contract value. The specific margin requirement is set by the exchanges, and varies for different futures contracts, depending on recent price volatility, legal regulations and several other factors.

Let’s look at an example of how margin and leverage work in futures. Suppose gold is trading at $950 per troy ounce. If the required margin was 5 percent, that’s $47 per ounce. As one futures contract represents 100 ounces, therefore the trader who buys or sells a contract would control $95,000 worth of gold for an initial investment of $4,700. Now imagine the price rises to $1,000 before the expiration date of the contract. The net profit would be: $1,000 – $950 = $50 per ounce. So, for one contract, $50 per ounce x 100 ounces = $5,000. The percentage of profit is: $5,000/$4,700 x 100% = 106.3%. Considering the modest amount invested, this represents a very decent return.

The “double edged sword” of leverage is that the price can just as easily, and sometimes even more quickly, fall. So if gold were to fall to $900, your net loss would be $5,000, more than your initial investment of $4,700. You now owe more. In that vein, leverage and margin can be very useful tools, but they can also be dangerous ones. The use of leverage requires making decisions based upon your personal investment experience and the amount of risk you are willing to take.

If you are interested in using leverage to enhance your portfolio there are many different strategies available, even ones with defined risk.

Tom Power is a Senior Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted division. He can be reached at 800-682-8325 or via email at tpower@lind-waldock.com. Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

Futures trading involves substantial risk of loss and is not suitable for all investors.