The current scenario of equity, commodity and forex markets is very volatile. It’s extremely difficult for investors to speculate the direction where the market is heading. There are many investors on the global platform trading in the futures market. It is considered to be most risky and speculative of all the markets. Let’s go in little depth to understand the term futures market and its function before actually going to the concept of leverage.
Basically, a futures contract is an agreement between two parties that commits one party to sell a security or commodity to the other at a given price and on a specified future date. This makes it possible to transfer the risk from those who want to avoid it (hedgers) to those who are willing to accept it (speculators). Hedgers can be individuals or firms that make purchases and sales in the futures market solely for the purpose of establishing a price level months in advance for something they later intend to buy or sell in the cash market. Their sole purpose is to protect themselves against the risk of an unfavorable price change in the interim.
Example:
An individual enters into a futures contract to sell 100 shares of ABC Ltd. at Rs.1000 each after one month in the futures exchange. This contract protects the price he/she is intending to get for this stock in the period of one month.
With the basic plot of the futures market clear it will be easier to understand the concept of leverage in the futures market and why it is a double-edged sword. The leverage of futures trading results from the fact that only a relatively small amount of money (known as initial margin) is required to buy or sell a futures contract. For example, a deposit of only Rs.100,000 might enable an investor to buy a futures contract representing Rs.1,500,000 worth of a particular stock/commodity. The initial margin is typically 5 to 15 percent of the value of the underlying contract, although in some cases it is even more or less. The smaller the margin in relationship to the value of the futures contract, the greater will be the leverage and risk.
High leverage can produce large profits when compared to the initial margin if the speculator correctly anticipates the future price change. Alternatively, if prices move in the opposite direction from what was anticipated, the result would be large losses. Thus, the double-edged sword.
Another Example:
An investor anticipates rising stock prices and buys one December Nifty index futures contract (lot size: 100) at a time when the S&P Nifty is trading at 2800. The initial margin required is Rs.28000 (assuming 10% margin cost). The value of the Nifty futures contract is calculated by multiplying the current level of the S&P Nifty by 100 (the lot size) i.e. the contract value is Rs.280,000 (100 x 2800); each point change in the index represents Rs.100 gain or loss.
Therefore, an increase in the index from 2800 to 2850 would increase the investment (50 x Rs.100 per point) Rs.285,000 i.e. a profit of Rs.5,000. A decrease of S&P Nifty from 2800 to 2400 during a contract period in this volatile markets would wipe out the investment to (400 x Rs.100 per point) Rs.240,000 i.e. a loss of Rs.40,000.
Although, a futures contract provides exactly the same actual profit as owning or selling short the actual securities or commodities represented by the contract, the low initial margin magnifies the percentage profit or loss potential. So, it can be concluded that in this market, speculators must be prepared for the possibility of losing their investment in a single day. An investor who is not reconciled to that possibility should avoid this market altogether.
