Tuesday, October 26, 2010
E Mini Futures Leverage Explained
In the futures market, margin refers to the initial deposit or "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses.
When you either buy or sell an E Mini futures (or any other futures contract), the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised.
The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.
Let's say that you had to deposit an initial margin of $6,000 on a, E Mini S&P 500 contract and the maintenance margin level is $4,000. A series of losses dropped the value of your account to $3,000. This would then prompt the broker to make a margin call to you, requesting a deposit of at least an additional $3,000 to bring the account back up to the initial margin level of $6,000.
In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay (deposit into your margin account). It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss.
Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky). The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. So for an initial margin of $6,000 for the E Mini S&P 500 contract, you may be able to enter into a long position in a futures contract valued at about $59,000, which would be considered highly leveraged investments.
You already know that the futures market can be extremely risky and, therefore, not for the faint of heart. This should become more obvious once you understand the arithmetic of leverage. Highly leveraged investments can produce two results: great profits or greater losses.
As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. For example, say that in anticipation of a rise in stock prices across the board, you buy an E Mini futures contract with a margin deposit of $6,000, for an index currently standing at $1182. The value of the contract is worth $50 times the index (e.g. $50 x 1182 = $59,100), meaning that for every point gain or loss, $50 will be gained or lost.
If after a couple of months, the index realized a gain of 5%, this would mean the index gained 59 points to stand at 1241. In terms of money, this would mean that you as an investor earned a profit of $2,950 (59 points x $50) before any commission costs.