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What is Leverage?

What is Leverage?

In our last lesson we finished up our discussion on the different basic order types that traders use in the futures market, with a look at the Trailing Stop. In today's lesson we are going to continue our discussion on the logistics of futures trading with a look at how margin and commissions work in the futures markets.

Trading on margin very simply means the ability to control a certain size position without having to put up the full value of that position in cash. Margin allows a trader to magnify both the potential gains, and the potential losses on an account. In this lesson we are going to cover margin as it relates to futures trading, so if you need a basic overview of how trading on margin works, see the links below this video for more information.

There are two primary advantages of trading futures over trading stocks which relate specifically to margin. The first, is that futures traders generally have access to much lower margin requirements than most stock traders. Generally the maximum leverage available in the stock market is 4 to 1, meaning that you have to put up at least 25% of the value of the position in order to remain in the trade, which would magnify your gain or loss by 4 times, compared to a position without margin. In the futures market, intraday margin levels can go to 100 to 1 or greater. This means that a trader only needs to maintain as little as 1% of the position value, in order to remain in the trade, potentially magnifying gains and losses on a trade by up to 100 times. While the ability to magnify potential gains is generally seen as an advantage to futures traders, it also comes with an added level of responsibility, as loss potential is also magnified by the same amount.

The second advantage of trading futures over stocks as it relates to margin, is that you do not have to pay for the use of margin as you would in the stock market. While you only have to put up a portion of the trade value when trading on margin in the stock market, ultimately the full position value is needed to place the trade. Because of this stock traders must borrow the rest of the trade value from their broker, and as this is a loan, they pay interest on the money they borrow. In the futures market, margin is seen as more of a "performance bond" or as money that you have to put up to make sure that you can make good on any losses incurred on a trade. Because of this you are not required to have the full position amount in order to place a trade in the futures market, which means there is no interest paid when trading on margin.

There are several other nuances as it relates to margin that it is important to understand when trading futures. Firstly, unlike in the stock market where margin requirements are generally the same for most actively traded stocks, in the futures market margin requirements differ depending on what futures contract you are trading. The reason why is because in the futures market, margin requirements are set based on volatility and position size, meaning that the more volatile a futures contract is, the higher the margin requirement is generally going to be.

Just as in the stock market there is an initial and a maintenance margin requirement for futures contracts, meaning that you must have a certain amount of money in your account to initiate a new position, and then a certain amount of money in your account to continue to hold or "maintain" the position once it is initiated. These levels are set by the exchange and while a broker can require a higher margin level than the minimums set by the exchange most do not. Lastly, it is important to understand here that these initial and maintenance margin requirements apply only to positions which are held overnight, and most futures brokers offer a lower margin requirement to traders who open and close positions within the same trading day.

As an example, the current initial margin for holding an E Mini S&P contract overnight as set by the futures exchange is $6,188, and the current maintenance level is $4,950. The day trading margin as set by the Apex Futures is $500 for both the initial and the maintenance margin.

So as most traders open and close their positions within the same trading day when trading the E Mini S&P, they need to have at least $500 in their account when trading with Apex in order to initiate and maintain a position, per contract traded. If a trader is planning to hold an Emini S&P contract overnight, as of this lesson they will need to have at least $6,188 in their account in order to initiate the position, and at least $4,950 in their account in order to maintain the position. If the trader drops below these levels then the broker has the right to liquidate their positions, and/or they will get a telephone call from the firms margin desk, to arrange to have additional funds to be deposited into the account.

While overnight margins are set by the exchange and generally the same from broker to broker, day trading margins are set by the broker and therefore vary widely. One of the reasons why I have chosen to recommend Apex Futures, is because they offer $500 day trading margins, which are among the lowest in the industry. Keep in mind however that leverage is a sword that cuts both ways, so while increased leverage amplifies the potential gain on a position, it also amplifies the potential losses.

Lastly it is important to keep in mind that although it is not a super common occurrence, margin requirements can be changed by the broker or the exchange at any time due to increased volatility in the markets. It is important to understand here that if requirements are raised, then traders will be required to have the set maintenance margin amount for existing positions, as well as any new positions which are initiated.

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