By Lamon Rutten

A General View on Leverage in Futures Trading

One of the main value propositions of futures markets is that you can trade with leverage. You can get exposure to the change in value of USD 10,000 worth of a commodity or a currency by investing just USD 200 or so of capital (this is called the “margin”). If that commodity then changes just 2 per cent in value in the direction that you had been anticipating, you make a 100% profit on your investment. But on the other hand, if you were wrong and the price changes just 2 percent in the opposite direction, you lose all of your margin. That’s one of the reasons why in futures trading, you should never expose more than a fifth or so of your capital in any single trade.

The broker will ask you to pay the margin to protect himself against the risk that, if you guessed wrong, you will be unwilling to pay up. If the price moves against you, the broker will inform you that the margin that you paid is no longer enough, and you have to top it up. If you do pay in time, then he will close out the position – the result is that you will no longer have a futures position, and you may even end up owning money to the broker. 

A margin of 2-2.5%, or in other words a leverage of 40-05 times, is quite common in futures trade. If you only trade during the trading day (that is to say, you do not carry any positions overnight), the leverage offered can be even 100 times. This leverage is generally considered a good thing: you can manage your risk, or take a speculative position, at a low cost of capital.

Futures Exchange on Leverage and Margin

So, as one can expect, many investors will think that if 40 times leverage is a good thing, than certainly, 200 times leverage is even better. Many over-the-counter (OTC) brokers and OTC trading platforms capitalize on this belief by offering such large leverage. It’s an effective marketing gimmick, and even more attractive for the brokers because in fact, it adds considerably to the likelihood that the OTC broker will win and the investor will lose.

Why is that? Exchanges set margins on the basis of calculations focusing on the volatility of the commodity or forex contract. Exchanges calculate optimal margins, allowing investors the maximum leverage at which the likelihood of being forced out of a position is small. To simplify a bit, the margin will be set at a level that with a 99 per cent probability, the margin plus today’s price will be equal or higher than the price tomorrow at the end of the trading day. To translate this from the investors’ perspective: if I pay the exchange-calculated margin, there is less than a 1 per cent risk that before the end of the day tomorrow, I will be forced out of my position by the broker because my margin is insufficient.

If the margin is even lower than that offered by the exchange, the risk that the investor will prematurely be forced out of his position increases exponentially. OTC brokers and internet trading platforms like that – it’s an easy profit for them. And the less scrupulous among them will deliberately manipulate prices during the less active trading hours to force investors out of their positions. For the investor, it is death by a thousand cuts – little by little, his capital disappears through small trading losses and the brokers’ commissions. 

Conclusion on Leverage in Commodity and Forex Market

In commodity and forex markets, prices do not increase or fall in a straight line. If you anticipate that, say, the crude oil price will increase from USD 58 to USD 58.50 per barrel, even if you’re right, the price will not move first to USD 58.01, then to USD 58.02 etc. Instead, prices will swing up and down around their trend line. Exchanges set their margins so that, as long as markets continue behaving in a more or less normal manner, investors are not kicked out of their position, as long as they guess the trend right. In contrast, an OTC broker who provides excessive leverage to an investor does so knowing full well that this strongly increases their opportunity to close out the investor’s position even if he gets the trend right – good for the broker, as he won’t have to make a pay out to the investor. In many countries, regulators have become aware of this, and to protect retail investors, have banned OTC brokers from offering excessive leverage (i.e., leverage higher than what exchanges offer).   

If it looks as if you’re offered the opportunity to make a higher profit at a lower cost that may well be too good to be true. In fact, by trying to reduce your cost, you just make it more likely that your buy or sell position will not survive long enough to start making a profit. So, be a smart investor, and say no to excessive leverage.