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?

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    I think it wasn't supposed to be private investors' playground - it was for companies that physically want that oil at that future date. They never saw a reason to change it, even though nowadays people play the markets. – Aganju Mar 25 '20 at 23:54
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    @Aganju But speculators are needed to some extent to take on risk that isn't wanted by those who want to buy and sell the actual oil. – Michael Mar 26 '20 at 1:52

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.

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.

  • This was very helpful, thanks. By "So if oil is at $55", you mean if ends being priced at $55 at the termination of the futures contract, don't you? – Paul Razvan Berg Mar 26 '20 at 13:08
  • @PaulRazvanBerg Correct- I've updated that. Thanks. – D Stanley Mar 26 '20 at 13:28

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.

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