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July 13, 2015 - Lower Risk Higher Returns Trading Futures Contracts
How Leverage in Trading Futures Can Boost Returns Over Stocks by The Street
Active traders often prefer trading futures, because a smaller amount of capital is required for the initial investment compared to stocks.
The impact of leverage is based on the type of asset an investor trades, said J.B. Mackenzie, director of futures and forex at TD Ameritrade, an Omaha-based online broker.
"Leverage for me is an investor's ability to increase their potential return in futures or equities by utilizing a small amount of their personal capital," he said. "The advantage of futures being a more levered product than equities is also one of its inherent risks."
As trading oil futures contracts gains in popularity, novice investors should focus on how they are more capital efficient because purchasing one crude oil futures contract is equal to 1,000 barrels of oil, said Anne-Marie Baiynd, a Detroit-based trader and author.
"Assuming that oil is trading at the price of $50, leverage or the initial margin allows us to participate in the trading of oil without having to fork over $50,000," she said.
The standard initial margin for the current crude contract $3,740 and the maintenance margin at $3,400.
"In essence, you are taking a short-term loan from your broker to engage in trading the contract, under the requirement that if your balance gets below the maintenance margin, you will deposit the amount you are short of the this number," Baiynd said.
Since a penny investment is worth $10 in crude oil futures, purchasing one contract (CL) equates to a notional value 1,000 times the initial investment. So if crude is trading at at $46.25, the notional value of purchasing the CL would be $46,250.00.
"This value is derived from multiplying 1,000 barrels by the current price of crude which was $46.25," Mackenzie said.
Since the margin requirement at TD Ameritrade to hold one crude futures contract is $3,740, an investor would need 8% in capital of the total notional volume to purchase a single contract.
"To hold an equivalent position in United States Oil Fund (USO) , an ETF, you would need approximately 4,133 shares since it was trading at a price of $11.19 on June 16, which is equal to $46,250," he said. "That position would have a 50% Regulation T margin requirement or approximately $23,125."
Utilizing a crude oil futures contract gives retail investors the opportunity to use more leverage or less capital than purchasing the USO ETF. While trading futures tends to be a more efficient use of capital, the risk for investors can be higher.
"Investors need to understand that any positive gains come with the risk that losses can come quickly as well," Mackenzie said.
Although trading both crude oil futures and USO ETF occur in $0.01 price increments, a penny move in crude oil is worth $10.00 while a $0.01 move in USO ETF would be the number of shares owned and multiplied by $0.01.
"It is critical that retail customers take the time to define their risk tolerance before placing a trade," he said.
Although all futures contracts are levered products, investors can lower their exposure or risk by opting to trade mini crude investments, because they have smaller margin requirements, tick value and contract size. When an investor decides to purchase a single crude oil futures contract (CL) which trades in penny increments, they are buying 1,000 barrels of oil by only meeting a margin requirement of $3,740. Its counterpart, the mini crude (QM), trades in $0.025 price increment for an investor to obtain 500 barrels of oil with a margin requirement of $1,870.
"It is important to remember that just because the mini crude product has a smaller margin requirement, tick value and contract size than the crude futures product, it doesn't mean that is a less levered product," Mackenzie said. "It can fit the risk appetite of some investors. Reducing personal risk also means there is not as much upside or downside."
One drawback of the mini crude contract (QM) is that it lacks the volume of crude (CL) and is not as fluid, said Baiynd. The gaps of the bid/ask in the mini crude be wider because the volume is low. QM also trades with a typical bid/ask spread of $0.05.
"Many people don't think about when the markets become illiquid," she said. "The bigger the difference is, the higher the risk. It can be a very big problem."
Liquidity should always be a concern no matter what investment you are trading, said Baiynd.
"With less leverage in the mini crude, you make less money as a $0.01 move equates to $1.00, instead of $10," she said.
Another issue for traders to consider is the transactional fee and how long you will have to hold the contract to pay both sides of the transaction fee - the points at which you buy and sell your contracts.
"Sometimes traders can trap themselves in a trade or prices can move very quickly against the trade and you can owe the brokerage way more than you initially invested, " said Baiynd. "That's the problem with leverage, when it goes upside down, it like falling out of a plane without a parachute."
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What Are Futures?
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.
A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset their position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
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