Commodities Trading Leverage

Commodities are often traded in the form of futures contracts. The name comes from the nature of the trade. A certain percentage of the asset price is paid and by undertaking this act a buyer indicates their agreement to deliver (or take delivery of) a set quantity of the good at a specified future date.

What advantage do futures have over trading the commodity directly? They're riskier, as they expire within a certain time period, and their values are more complicated to assess. The asset price is difficult to predict, and the price of a futures contract in the future is even more uncertain. Contracts are bought and sold in a way similar to stocks or options.

A derivative is a financial instrument that 'derives' its value from some underlying asset, so as such a futures contract has no inherent worth. So what do commodities futures traders know that some investors have yet to realize? One thing they know is the value of leverage.

Think of a teeter-totter in a children's playground. Assuming the pivot point under the horizontal plank is placed in the correct spot, a small child can lift an adult into the air. That force 'multiplier effect' has an analogy in financial markets.

Leverage is achieved when an investor can control - even though he doesn't own - 100% of a quantity of the good for somewhere in the vicinity of 5% of the price of the commodity. The 5% figure is known as 'the margin'. The specific number changes depending on recent price volatility, legal regulations and several other factors.

Presume that gold is trading at $580 per Troy ounce on the CBOT (Chicago Board of Trade). 5% of $580 equals $29. Therefore a trader purchasing a futures contract for 100 troy ounces can control $58,000 worth of gold for only $2,900. In effect, the broker loans the trader the rest of the money. Considering that commissions fall somewhere in the range of $15-$40 for a 'full turn', i.e. a pair of trades to buy and sell, it’s not a bad deal.

Now imagine the price rises to $585 before the expiration date of the contract. The net profit is: $585 - $580 = $5 per ounce. $5 per ounce x 100 ounces = $500. The percentage of profit is: $500/$2900 x 100% = 17.2%. When taking into account the modest amount invested, it’s a very decent return. And such price swings for gold happen almost daily. Obviously the price can just as easily, and even more quickly, fall.

There are other advantages that futures have over the spot market. Suppose you actually had enough capital to purchase 100 troy ounces of gold. You now have transportation, storage and security problems.

If the commodity in question were, say, oil your problems intensify. Supposing you could afford to purchase, transport and store 1,000 barrels of oil (the standard minimum contract amount, equal to 42,000 gallons), you are unlikely to find a dealer to take it off your hands. Usually they only deal with professionals who conduct transactions in very large quantities.

So unless you bought it to use rather than trade, you are going to find it difficult to sell again. Even if you do find a buyer, you again have a transportation problem and expense.

Because of this, almost no traders ever see the actual commodity. However, don't forget that, unlike options, futures contracts denote the obligation to deliver (or take delivery of) a good by a certain date. It is rare for contracts to be for longer than a year.

Usually, of course, the contract is sold on or before the expiration date at either a profit or loss (or breakeven). The goods themselves are ultimately transferred to an end consumer (jewelers, refineries, bread making companies, etc) by a specialty broker.

By using the leverage they provide, futures provide a large scope for profit.