Commodities - Leverage

Most commodities trades are executed in the form of futures contracts. A specified percentage of the asset price is paid and a buyer accepts the obligation to deliver (or take delivery of) a set quantity of the good at a future date. Hence the name.

Why do futures offer any advantage over trading the commodity directly? They're riskier, since they expire within a certain amount of time, 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 so. Contracts are bought and sold in a way similar to stocks or options.

As derivatives they have no inherent worth. A derivative is a financial instrument that 'derives' its value from some underlying asset. What do commodities futures traders know that some investors have yet to learn? One thing they know is the value of leverage.

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

For somewhere in the neighborhood of 5% of the price of the commodity, an investor can control - even though he doesn't own - 100% of a quantity of the good. That's leverage. The 5% figure is known as 'the margin'. The specific number varies depending on recent price volatility, legal regulations and several other factors.

Suppose 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, say, 100 troy ounces, can control $58,000 worth of gold for only $2,900. The broker, in effect, loans the trader the rest of the money. Not a bad deal considering that commissions are in the range of $15-$40 for a 'full turn', i.e. a pair of trades to buy and sell.

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%. Considering the modest amount invested, a very decent return. And such price swings for gold happen almost daily. It goes without saying that the price can just as easily, and even more quickly, fall.

Futures have other advantages 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. Even if you could afford to purchase, transport and store 1,000 barrels of oil (the standard minimum contract amount, equal to 42,000 gallons), very few dealers are going to take it off your hands. They only do business with professionals who deal in very large quantities.

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

Small wonder that almost no traders ever see the actual commodity. Nevertheless, don't forget that, unlike options, futures contracts carry the obligation to deliver (or take delivery of) a good by a certain date. Rarely are the contracts for longer than a year.

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

Take advantage of futures and the leverage they provide.