Be Smart When Using Leverage

08/09/2011 6:00 am EST

Focus: STRATEGIES

This example shows the true profit-producing power of leverage in the marketplace, but traders must be educated and informed in order to keep losses from piling up quickly as well.

The market action in the past few sessions has no doubt resulted in margin calls for traders who were leveraged on the wrong side of this market. It’s a good opportunity to re-visit leverage and examine how smart traders use margin to their advantage.

The first thought conjured up when laypeople hear the words “futures trading” is that it’s pretty much just another form of gambling. They’ve all heard some anecdote of a distant relative that lost a lot of money trading pork bellies, or the story of how the former First Lady turned a mere $1000 initial deposit into a staggering sum of $100,000 in just ten months by trading cattle futures. Some find these stories far-fetched and generally think this would not be possible unless there were something improper at work.

The reality is that it’s possible to take a relatively small sum of money and grow it exponentially in the futures market. That’s due to the leverage afforded in these markets. Leverage, when used properly, can amplify gains, but it can also work to magnify losses.

Leverage, in my view, is a beautiful thing, but only when used properly, of course. How many rich people do you know who got that way using their own money? Not many. But just like anything else, too much of a good thing can be disastrous. We know this all too well these days, as the reckless overuse of leverage was almost responsible for a total financial meltdown three years ago.

In the futures market, the leverage is approximately ten-to-one for most contracts. This is quite tame in comparison to the spot forex market, which is leveraged 50-to-one. As an example, the S&P E-mini contract has a notional value of $50 times the contract, so at the current level of 1350, that is $67,500.

The full margin (amount needed to hold a contract overnight) currently is $5000. The intraday rate is 25% of that, or $1250. At first blush, it seems dangerous to have that amount of leverage, but if we look at it from an opportunistic perspective, it looks much different.

Here’s an example comparing the E-mini Russell futures contract versus the corresponding ETF, the iShares Russell 2000 Index Fund (IWM). First, the contract specifics for the E-mini Russell 2000 are as follows:

  1. Full margin (for overnight trading) is $3500 (intraday margin is $1000)
  2. $10 minimum fluctuation ($100 per point)
  3. Notional value at the current index value of 850 is $85,000 ($100 x the index)

ETF requirements for the same movement:

  1. 1000 shares
  2. Full margin $42,500 (intraday margin $21,250)

NEXT: Two Key Qualities for Using Leverage Safely

|pagebreak|

In doing some quick math, we can conclude that the return on investment for the futures contract trumps that of the ETF. A one-point profit (say a move from $84 to $85 in the ETF) would net $1000, or roughly a 4.5% return, whereas the futures return on the same move (ten points in the futures contract) is equal to a bit over 30%.

See related: The Leveraged ETF Safety Kit

Incidentally, because these are smaller companies, the index tends to be more volatile, and thus, this type of movement is very common in the Russell 2000 index.

I know some of you are thinking that for those types of returns, one must have to assume a tremendous amount of risk. Actually, that’s the beauty of trading futures; you don’t have to take as much risk as might be suspected. That’s because we only take trades with very low risk and high reward.

This requires a viable strategy, and the discipline to follow it. A big word of caution: If you possess neither the strategy nor the discipline, then futures trading is most definitely not for you. However, by gaining the proper knowledge, these can be honed.

See video: E-mini Trading Made Easy

I don’t expect everyone reading this piece to go out and open a margin account tomorrow; however, for those of you that have a limited amount of capital or plan on trading as a way to generate income, this is definitely worth looking into—albeit with caution.

Leverage can be a tremendous asset if used smartly. Think about your first home; if the bank hadn’t been there to provide you with 80% or 90% of the financing (leverage), there would have been a slim chance to acquire it and all the benefits that you have enjoyed, provided you bought at the right time.

The same can be said about other leveraged investments such as futures. So check out a class or get further information on the futures market to get started.

By Gabe Velazquez, instructor, Online Trading Academy

Related Articles on STRATEGIES