General Theory - Leverage

Leverage, borrowing to increase the return on one's investment, is what attracts speculators to the futures markets. Speculators, being individuals, tend to have less money on hand than a major oil company or investment bank would. But even with only tens of thousands of dollars to spend, instead of tens of billions, speculators have access to margin with which they can exercise some control over a great deal of underlying commodities. Margin requirements are much lower on the futures exchanges than on the stock exchanges. A futures trader need have only one dollar in his long portfolio for every 10 or 20 dollars in his short portfolio, as opposed to the one-to-one required by major stock bourses. This 5 to 10% initial margin requirement is the norm, although it can be raised by the exchange or its regulators, in response to market volatility.

Margin Trading

Leverage allows for short-selling, which is also easier in the futures market than in the stock market in terms of procedure. Shorting the futures market involves nothing more than buying a contract. If you believe in July that the price of ethanol is headed lower, first you'd contact your broker to ensure that your margin requirement was met. Next you would sell short a contract at the prevailing rate of 2'542 (which means $2.542/gallon) with the expectation of making an offsetting purchase at a lower price before the contract expires, say in November. If you can cover the contract at a lower rate, then you make a profit.

The above ethanol contract was for 29,000 gallons, that is, a railcar full. It would probably take you somewhere between 15 to 20 years to burn that much fuel. People are by nature risk-averse so, if you did not engage in futures trading for your own consumption and for thrills, then you must have done because you expected to make enough money off the transaction to compensate you for taking on the exposure. That, then, is the true mark of a speculator.

Both hedgers and speculators contribute to market liquidity and price stability. On the long side, a hedger secures a price to protect against higher prices and a speculator secures a price in anticipation of higher prices. On the short side, a hedger secures a price to protect against lower prices and a speculator secures a price in anticipation of lower prices.

General Futures Terminology
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