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Avoiding the Dangers of Futures Leverage

, | May 7, 2018 | By

Online futures trading is an appealing pursuit for people keen on maximizing the potential of their own venture capital. Each day, market participants around the globe buy and sell a wide-variety of futures products in an attempt to grow personal wealth. The implementation of financial leverage plays a key role in the eventual outcome of every transaction.

In elementary terms, leverage is the process of using a little to control a lot. Just as a crowbar and fulcrum may be used to move an enormous object, futures leverage allows a small amount of capital to control an asset with a much larger value. If used appropriately, leverage gives retail traders a chance to engage the futures markets side-by-side with institutional participants.

The Impact of Futures Leverage

As the old adage goes, financial leverage is a double-edged sword. This statement may never be truer than in futures trading. Increasing the leverage for a trade will certainly bolster gains — or losses.

The single most important thing to remember about futures leverage is that it increases market exposure exponentially. As the number of contracts applied to a position is raised, risk and reward grow dramatically.

Any trades are educational examples only. They do not include commissions and fees.

For instance, take a look at how fast the stakes go up when the degree of leverage is raised in the WTI Crude Oil futures market:

Number of Contracts Margin Requirements (Intraday) Value Per Tick
1 $1000 $10
2 $2000 $20
3 $3000 $30
4 $4000 $40
5 $5000 $50

It is not difficult to see the relationship between increased leverage and risk exposure. Buying or selling one lot in WTI crude oil has a per tick cost of $10, while a five lot is $50. This is a five-fold increase in market exposure.

Even though reduced margin requirements enable traders to boost returns, it’s easy to take an untenable position given available capital resources. A proper understanding of margins, tick value and inherent product volatility are crucial to using futures leverage properly.

Applying Leverage: How to Avoid Catastrophe

Many pitfalls and challenges jeopardize the longevity of a futures trading account. Unexpected pricing volatility and improper money management are two of the largest. Although market participants cannot directly control volatility, employing sound money management is in the job description of every trader.

Here are a few basic guidelines that will help minimize the chance of prematurely blowing out your trading account:

  • Don’t overextend: Position sizing is an integral part of applying leverage properly. Taking an abnormally large position in the market may result in a violation of margin requirements or lead to account liquidation or an extraordinary loss.
  • Respect volatility: Each product displays unique behavior. For instance, markets such as the E-mini S&P 500 and WTI Crude Oil trade with varying degrees of volatility and become active at different times. When increasing leverage, be sure to understand the product-specific tendencies of price action.
  • Balance risk and reward: Aligning risk to reward is one of the most important aspects of futures trading. Leverage amplifies both of these elements, thus playing a key role in any money management strategy. If a position is too large, stop losses may have to be exceedingly tight, and if it’s too small, returns on premium trades lag. Balancing risk and reward can be a challenging task, but one that is absolutely necessary to optimize performance.

Perhaps the most effective way to avoid the dangers of futures leverage is to clearly define its role within your comprehensive trading plan. By quantifying the risk associated with increased leverage thoroughly, money management decisions become routine.

Getting Started

The futures markets are fast-paced environments where assuming risk is a part of day-to-day operations. Being aware of when to increase or decrease the use of leverage is critical to employing your capital efficiently.

For more information on how to become involved with futures, consult the industry professionals at StoneX. With more than 25 years in the market, StoneX has the experience and resources to help you achieve your trade-related goals.

Download the eBook: Futures and Options Strategy Guide