Leverage can seem risky, but when used properly it is a game changer. Leverage is the ability to control a large contract value with a relatively small amount of capital. In the futures market, that capital is called performance bond, or initial margin, and is typically 3-12% of a contract’s notional or cash value.
Assume that one E-mini S&P 500 future has a value of $103,800. You initiate a position by posting an initial margin of at least $5,060. In other words, you will have exposure to $103,800, but you have only put down a small percentage of the value. This is called greater capital efficiency.
Another benefit of leverage is gaining increased exposure. For example, if you have $10,000 with which you would like to express your opinion in the gold market. How can you maximize your $10,000? One option is to buy physical gold at $1,250 per ounce. This would afford you 8 oz. of gold.
Another option is to purchase shares of a GLD ETF. If the current price is $125 on GLD, you would be able to purchase 160 shares. That would afford you $20,000 in market exposure and you control the equivalent of 16 oz. of gold.
ETFs are subject to the Federal Regulation T requirement for 50% margin of purchase price, which means you can control $20,000 of exposure with $10,000 in capital.
A third option is to buy a Gold futures contract, which represents 100 oz. If initial margins are $4,400 you can guy two Gold futures contracts. You will have exposure to the equivalent of 200 oz. of gold.
Experienced futures traders understand the power of leverage, its risks and its potential benefits when used as part of a well-thought out risk management plan. Now you, too, can harness the power of leverage for greater capital efficiency and increased exposure.
Peter Knight Advisor