Investing in any financial instrument includes the risk of losing capital. Some investment strategies have a higher degree of risk than others, which also implies a higher potential for reward. It is important for the individual trader or investor to understand his or her risk tolerance with respect to the trading and investment vehicles they choose before allocating capital to any market.
One concern I hear from traders and investors is that the futures markets are too volatile for them. Upon hearing this, I always ask if they are aware of the many ways to reduce risk or define risk in the futures markets, and many have not. More than a few people will stay away from the futures markets because of what they have heard second-hand without researching what the risks are and learning how to reduce them.
One of the most common reasons individuals believe the futures markets are too risky for them is because of the leverage involved in futures trading, or the ratio between the amount of capital one can control in a particular market compared to the amount of capital one must have to initiate a position in a trade in that market.
The amount of capital one needs to trade a futures contract is referred to as margin, and is a small percentage relative to the actual size of the futures contract. For example, the margin on one corn futures contract is $2700. However, if corn is trading at $6.6225, one can actually control $33,112.50 ($6.6225 x 5,000 bushels) with a $2700 margin, which means that person has approximately a 12:1 leverage ratio. Because corn moves in increments (or “ticks”) of .0025, each movement of the corn market will either increase or decrease your account by $12.50 (.0025 x 5,000 bushels) depending on whether you have established a long or short position in the market.
To illustrate the impact that leverage can have on one’s account, let’s consider the following example: if you were to initiate a position in the corn market at the opening price and it made a 40 cent move, which is the limit move for the corn market in a single trading day, this would be a gain or loss of $2,000 for one position in a corn trade. While this would be a very large move for the corn market in a single trading day, and would most likely only take place after a large report or news that highly influences that market, it could certainly happen. Also, remember that you can always use stop losses to help reduce your risk, but depending on the liquidity in the particular market one is trading, a stop loss can be missed.
So you are probably wondering by now, how can I reduce my risk in the futures markets? The answer is simple. Use mini contracts! What is a mini contract? A mini contract is a futures contract of smaller size, which offers less leverage to the trader. Mini contracts can be viewed as “training wheels” for the beginning trader before increasing one’s leverage, or a way for a more conservative investor to gain access to the commodity markets. Still, as with futures trading, mini contracts have risks too.
Using our corn example, I will illustrate the difference in leverage and RISK between trading a standard corn futures contract and a mini corn futures contract. Going back to our previous example, we know that if we were to initiate a trade in the standard July corn futures contract at $6.6225 we would be controlling a $33,112.50 position with $2700. So what is the difference when trading a mini corn futures contract versus the standard contract? A mini corn futures contract is equal to 1,000 bushels rather than 5,000 bushels. This means that if we were to initiate a position at the same price in corn ($6.6225) as we did in our previous example, we would be controlling $6,622.25 (1,000 bushels x $6.6225) instead of the $33,112.50 (5,000 bushels x $6.6225) that we would be controlling when initiating a position in the standard futures corn contract. A limit move of 40 cents is now worth $400 for the mini, as compared to $2000 for the standard contract. This is an 80 percent decrease in total risk and a better approach for the more conservative trader!
There are many ways to reduce risk and take more conservative approaches in the futures markets, and after reading this article you should have a better understanding of one great way to take advantage of the futures markets without being exposed to as much risk. While we have only used examples of mini contracts in the corn futures market, traders and investors should understand that there are many markets that offer the same access to reduced leverage, including the indices, metals, currencies, energies, and grain markets. To learn more about mini contracts or speak with a broker about the many options for trading in the commodity futures markets please call 1-800-800-3840.
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