Commodity futures trading offers the potential for very lucrative returns relative to money invested. With the potential for great reward comes the equal potential for great loss. Leveraging is the key to profiting.
The ability to reap great returns or substantial losses is a function of leverage. Highly leveraged trading has high risk of loss, while low leverage reduces loss. Even in low leverage positions, the loss can be substantial depending on the trading situation.
The degree of leverage depends on the amount of money used to control a commodity of a specified value.
The amount of money needed to control a futures contract (called margin) is usually less than 10% of the market value of the commodity. In some cases the margin is less than 1%, which is a much more highly leveraged position.
Before a commodity can be bought or sold on the futures market, an account must be established with money called initial margin. This is a good faith deposit designed to guarantee performance of the futures contract. Should a futures position incur losses below maintenance margin, a margin call is initiated requiring the customer to bring the account back to the initial margin level. Maintenance margin is about 75% of the initial margin requirement.
While the degree of leverage is an indicator of the risk factor in trading a commodity, volatility is also an important consideration. Volatility refers to price movement of a commodity. A highly volatile commodity that makes sudden and large price swings has more risk than a commodity with stable price movement. Two equally leveraged positions will have different risk factors depending on the degree of volatility.
Even though futures trading is considered highly risky due to the leverage factor, it is possible to deposit more margin than required into your account. By reducing leverage and trading conservatively in quiet markets risk is substantially reduced. The futures market is not inherently designed to be high risk, and may be tailored to meet personal factors and resources.
ABOUT THE AUTHOR
Brett Krkosska provides how-to advice on small business and home-based work issues. He is the founder of HomeBizTools and the publisher of Straight Talk, a syndicated column that offers a unique perspective on today’s business issues.