Why does the futures market use stupendously high leverage?

Question

From Investopedia:

The futures markets typically use high leverage. Futures contracts may only require a deposit of a fraction of the contract amount with a broker.

I know how margin trading works, but I want to understand why it is so common in the futures markets.

For instance, why does an oil futures contract need to be 1,000 barrels and not less? This makes the basic contract be worth in the five-digit ballpark.

Is it because the market used to cater mostly to institutional investors and those market participants who actually do the physical settlement of the underlying commodities?

Answer 1

For instance, why does an oil futures contract need to be 1,000 barrels and not less? This makes the basic contract be worth in the five-digit ballpark.

Ancient civilizations bartered. In the 1500s, explorers set forth to find desired goods, particularly salt and spices. In order to manage the risk, the concept of futures evolved with merchants and explorers locking in a price. It was a practical evolution of risk management and contract standardization.

The commodities markets evolved primarily to allow producers and consumers to be able to buy and sell commodities. Contract size is large because the quantities are practical for the producers and consumers (think Kelloggs, Proctor & Gamble, etc.). It's not an arena designed for the little guy.

Answer 2

Leverage is not necessary with a futures contract. The entire cash value of the underlying commodity can be held in the account. Well, the account will note the amount of margin used from the free balance but the investor can certainly be proven to be unleveraged by the cash balance.

In fact ticker USO is a fund that accounts positions in oil using futures contracts but the fund is not really leveraged. The fund avoids leverage by holding a large amount of Treasury Bills.

As for the size of the futures contracts, there is a Mini oil contract but not a Micro oil contract. There is a Micro gold contract. And the indices have Micro E-Mini contracts available.

Answer 3

I know how margin trading works, but I want to understand why it is so common in the futures markets.

Because with futures, unlike stocks, you do not exchange cash upfront, therefore leverage (without any margin account) is infinite. So margin is required to protect the exchange (or counterparty for off-exchange trades) from you experiencing a greater loss than you can afford.

Say you "buy" an oil futures contract at $50. You do not pay $50 for this and then sell it for the current price of oil - you have simply entered into a contract and will settle for the difference. So if oil is at $55 when the contract terminates, you will receive your $5 profit (technically you would buy a barrel of oil for $50 and be able to sell it for $55, but most futures are financially settled instead).

So you have potentially infinite leverage (zero upfront investment) without any margin. The less margin that is required, the more leverage you have.

Answer 4

There are multiple protection systems to lower credit and counterparty risk. Margin is just one of these.

This means that the exchange can offer trading leverage as a feature, while still maintaining a low risk system. So you don't need to go to a bank for a loan to get leverage.

Futures contracts are designed to offer attractive trading liquidity and capabilities to institutional investors (both hedgers and speculators) because that's where the big fees can be made.

Most participants are institutions and trade in bulk. This is why the contract sizes are 'large', it makes the trade size numbers smaller (as numbers of contracts) easier to read - seriously. I've actually seen people mis-trade OTC FX deals because 'there were too many zeros and I missed one'. Eg, 1000000000000 KRW - is that ~1bn USD or ~100m USD? etc

There is another answer here, which is to do with encoding numbers in computer systems. The upper size limit for a signed 32 bit integer in most computer systems is a little over 2.1bn. However, that is a small number of dollars, Yen, euros etc. To improve speed in computer systems, numbers like number of contracts in a trade is kept under ~2bn so that they fit in a 32 bit integer, by making each contract worth 10k USD or more etc.