Let's talk about the risk in futures tradingI cannot emphasize enough how important it is for any trader to fully understand the risk in futures trading. Futures are traded on margin. This means you don't have to deposit the full value of the contract to your broker, even though you get to keep all the gains on the contract. You will also be liable for all the losses. Losses can exceed the amount you deposit with your broker. This gives the potential for both high returns and large losses.Let's look at crude oil futures. One standard oil contract is for 1,000 barrels of oil. Currently oil is priced at $92. This means the contract is worth $92,000. One broker has an initial margin requirement of $9,200 and a maintenance margin requirement of $6,825. Let's say that Bob, a fictional character, wishes to speculate that oil will be over $110 per barrel before July 2008. He buys a standard contract of 1,000 barrels with a July 2008 expiry and deposits the minimum margin requirements. As illustrated above these combined amount to $16,025, this is the initial and maintenance margin requirements added together. First we will look at what happens if oil shoots up to $130 per barrel on expiry of the contract: Bob bought 1,000 barrels, so his investment is now worth $130,000. It was only $92,000 to begin with. Bob is happy as he did a lot better than he hoped, he has made a profit of $38,000 with an investment of just $16,025. Now let's look at what happens if oil falls in price to $60 a barrel on expiry: Bob bought 1,000 barrels, so his investment will be worth $60,000. It was $92,000 to begin with, so he has a loss of $32,000. This loss is around double his original stake and he will have to pay the difference.
As you can see, with the use of margin you can quickly earn or lose money. A way of lowering the risk is to fund a bigger proportion of the contract with your own money. There are emini futures that allow you to trade much smaller amounts. Many instruments like oil are extremely volatile and using too much margin can be extremely risky. It is often a good idea to paper trade before you trade with real money. I hope this article clearly demonstrates the risk in futures trading and happy trading.
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