A common saying in financial markets asserts that leverage is the quintessential double-edged sword. That axiom may never be more relevant than it is in futures trading, specifically the crude oil markets. Led by the industry benchmark West Texas Intermediate (WTI) and North Sea Brent (Brent) contracts, crude oil futures are some of the most frequently traded derivatives in the world.
Driven by a variety of fundamentals, as well as technicals, WTI and Brent are dynamic markets that provide participants many opportunities. Featuring consistent volatility, robust liquidity and wide daily ranges, WTI and Brent crude are commonly referred to as the Wild West of the futures markets.
Leverage 101: Contract Size Is King
A great place to begin any discussion of oil futures leverage is by talking about contract size. In futures, a contract’s size is the quantity of the underlying asset upon which valuations are based. It directly determines the value of each tick, effectively defining the degree of risk exposure being assumed by the buyer or seller.
Fortunately for oil traders, the contract size between the two leading products is identical:
|WTI Crude Oil||Brent Crude Oil|
|Price Quote||U.S. Dollars & Cents||U.S. Dollars & Cents|
|Contract Size||1000 Barrels||1000 Barrels|
Leverage 101: Know Your Tick Value
No matter which product or market you’re trading, a good first step in applying leverage is identifying the minimum tick value. For instance, the minimum tick value of the E-mini S&P 500 (ES) is $12.50 while the E-mini DOW (YM) is $5.00. Larger contracts, such as CME Bitcoin futures (BTC) or silver (SI), cost the trader $25.00 per tick. As shown above, both WTI and Brent crude futures are valued at $10.00 per tick.
It’s vital to remember that as position size is increased, tick value grows accordingly. This is a key aspect of oil futures leverage — larger positions equal greater tick values. Take the following example as a basic illustration of how growing position size impacts the tick value of a crude oil futures trade:
|Number of Contracts||Tick Value|
This concept is elementary, yet many traders are blinded by the allure of extraordinary returns and ignore the negative implications of greater tick values. Without a firm grasp of how tick value can stress a trading account, catastrophic loss, margin calls, and premature position liquidations come into play.
For instance, take the following example of a WTI crude oil intraday play utilizing a $5000 trading account. Observe how increasing position size boosts tick value and enhances risk exposure:
|Contracts||Intraday Margin Requirements||Available Capital||Tick Value|
Assuming a $5000 account balance, taking a 1 lot position is doable. At $10.00 per tick, a given trade has 400 ticks of wiggle room before the position is liquidated or a margin call is placed. However, as the position size is increased, the margin for error shrinks exponentially. On only a 3 lot position, the cushion is reduced to an ultra-tight 66 ticks. At 4 lots, a negative 25 tick move in price will have your broker giving you or perhaps even automatically liquidating your position.
In practice, traders have many ways to put oil futures leverage into perspective. However, without a solid understanding of the concept of tick value, placing efficient trades becomes difficult at best.
Making the Most of Oil Futures Leverage
Financial leverage is a complex topic, but its general properties are similar throughout the world of finance. In all markets, the basic rule for leverage is: Use it recklessly and perish; respect its power and prosper.
For more information on the global oil markets, as well as on how leverage plays a big role in the futures game, contact a broker at Daniels Trading. Featuring the experience and knowledge gained from years in the industry, a member of the DT team can bring clarity to the sometimes intimidating topic of leverage.