Futures contracts, as you may know, are traded through the use of performance bonds, often referred to as margin. The margin required to take a position using a futures contract in many cases only represents a small fraction of the total value of the contract, making futures a highly leveraged trading vehicle. In other words, futures contracts represent a large contract value that can be controlled with a relatively small amount of capital. This aspect of futures trading results in greater profits and losses than a comparative non-leveraged investment utilizing the same amount of capital, providing a trader with better capital efficiency.
For example, if you have $200,000 of risk capital and you want to use it to speculate on the direction of the S&P 500, for purposes of this illustration, you have three choices:
>> Buy $200,000 of stock using all available capital. This can be done by purchasing an Exchange-Traded Fund (ETF), which for this example would be SPY. SPY seeks to replicate, net of expenses, the S&P 500 Index. It is regulated as, and trades in, equity (stock) like shares. Your exposure would be $200,000 worth of SPY shares (leverage of 1:1).
>> Buy the same stock (ETF-SPY) on margin, taking advantage of the 2:1 leverage available in equities. This allows you to control the same portfolio of stocks (ETF-SPY) by utilizing only $100,000 of available capital (leverage of 2:1).
>> Buy 2 E-mini S&P 500 futures contracts. This allows you to control approximately the same (actually, slightly more based on today’s contract value) portfolio of stocks by leveraging $10,550 (aggregate initial margin requirement of 2 contracts) of available capital. With the current front-month contract trading at 2290.00, two E-mini S&P 500 contracts represent approximately $230,000 of exposure of the S&P 500 Index stocks (leverage of 22:1).
In each case, you have exposure to the same type of market risks and opportunities, but in the final example, you gain the same amount of market exposure (slightly more) while tying up significantly less of your available capital. Please note that the figures above represent margin amounts as of today’s writing and are subject to change.
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Trading futures and options on futures involves substantial risk of loss and is not suitable for all investors.