0

Why do futures allow higher leverage? Shouldn't the risk of a futures contract be the same as the spot. In that case, why would brokers feel more comfortable handing leverage to futures traders vs spot traders?

3
  • You pay only margin.
    – AKdemy
    Feb 18 at 23:27
  • Sure but the clearing house doesn't care what you pay, they care that you can hold up your end of the deal, and this responsibility should theoretically be pushed to your broker to maintain a maintenance margin. Form your broker's POV, the risk is exactly the same between futures vs spot
    – Joe C.
    Feb 19 at 2:01
  • 1
    You "pay margin" ? Feb 19 at 18:41

1 Answer 1

3

Return is generally measured based on the amount initially invested. If you buy a barrel of oil for $80 and sell it for $100, you earn a 25% return ($20 profit / $80 invested).

With a futures contract, you don't initially pay anything. You enter into a contract to buy/sell something at an agreed upon price and date (and location for physically settled futures).

So if you "bought" a future to buy a barrel of oil at $80, you would pay nothing upfront. If the price of oil went to $100, you could buy the barrel at $80, sell it for $100, and make $20 profit with no initial investment so your relative return is infinite (20/0).

In reality, brokers require some margin to be placed to ensure that you can afford any losses, but that is generally a portion of the futures value, so there is some initial cash outlay, and return is not infinite, but is it several times higher than it would be without buying the oil upfront and waiting to sell it.

Also in reality, most commodity futures are settled before expiry, so one would instead sell the future for $100, collecting the $20 profit without having to pay anything other than margin.

So futures allow leverage by allowing you to invest more with the same initial outlay, or, they multiply relative returns by reducing the amount of initial investment, depending on how you want to look at it.

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .