TheRiskBlog

Very often a customer wants to learn all there is about the futures markets. He is not interested in the opportunity to make money in equities, all he wants is to trade futures. Now, there are a few things to know about these markets and how to deal with risk when trading futures. Here are things you really need to know…
When you trade in stocks you trade on a 1:1 basis. That means buying 1 share at a price of $10 warrants that you put up $10 (plus any brokerage fees). So the price of the stock is the price you have to pay for 1 share. If this price changes it will change the amount of money you get back at the end of your deal.
Normally people come to the conclusion that there is no leverage in this kind of trading because it is a 1:1 situation. This is not true though. Since your own trading account has a limit, the position size in equities determines the leverage you assume for your account. This is in relation to the limit of your account. Let´s look at an example. Let´s assume that our account size is $100.000. We bought 100 shares of AAPL at $195. So we had to put up $19.500 (omitting the brokerage fees for clarity in this example). This means we put up almost 20% of our account. If we had bought 200 shares instead for the amount of $39.000 that would have meant an investment of almost 40% of our account. So the more shares we buy the closer we get to 100%. But this is the beauty of it since we can go ahead and scale up our position by 1 share if we like. So we are able to control the exposure risk very precisely. We can also control our risk by controling the number of individual positions in our account. We assume more risk if we trade 6 different positions instead of 2.

Unfortunately this is not the case in the futures world. Let´s have a look at the YM the E-Mini DOW Jones Contract. The contract size is 5x the E-Mini DOW Futures contract. So at 10200 points this means the face value of our trade is $51.000. But we only have to put up the initial margin, at the moment around $3250. So again, our account is limited - let´s say it is the same $100.000 we used before. But this time we only put up a little over $3000 so we only put up a little over 3% right? Wrong since our contract will have built in leverage. In the case of the YM 1 point in the DOW will move our invested money by $5 so we have a built in leverage of 1:5 instead of 1:1 when trading stocks.

As long as the leverage is working for us, everything is fine, but when it goes against us we lose money faster than we would when trading stocks. The problem is the initial margin though. Since we only need to put up a little over 3% our account doesn´t have to be a $100.000 account in order to trade futures. We could have a $5000 account to do this. And this is exactly what most people have when they decide to trade futures. They have a small account and want to use the leverage to come up with more cash on less trades.

You can see the dilemma. The moment a small account moves against you but has huge leverage it will be wiped out real quick. The leverage does the trick.

So when do we use what? Even if you don´t like it, as long as our account size is small we have no real choice, we can only go for the 1:1 leverage solution so we have to stick to normal stock trading. But once we have made some cash and the account rises we can start to use futures to. At that point we can use the extra leverage since we can play it with the money we have made. The only other option is to use leverage when we start out with a huge account.

So in the end leverage is our friend when we are winning but it is our worst enemy when we are losing. Since we can not exclude losing when beginning to trade leverage needs to be very small in order to control risk in the first couple of trades in a newly opened account.

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