Leverage and the snowball effect

The big advantage of levering is that you can multiply the amount of money you are able to obtain, and then use this larger amount to invest in financial markets.

With this extra money you can bet on a number of horses at the same time, which could be interesting if you like to diversify your risk, or you can put more of your money on just one horse, your favourite. The profit from backing only one horse, providing you have picked a winner, will be much larger than profits from hedged investments. This multiplier can be huge.

Derivatives, like options and futures, are derived from standard asset classes like equity (or equity indices) and bonds. These assets are the underlying value of derivatives contracts. Options and futures are called derivatives because their values are directly derived from the prices of their underlying values, so when a stock price moves, the price of a stock option or stock future of that particular stock will change accordingly.

Buying futures

Here's a strange thing: If you expect the gold price to go up, you could (scenario 1) visit your local jeweller and physically buy one kilogram of gold, or you could (scenario 2) buy one gold future at DGCX.

If the market moves up, you will, regardless of which scenario you chose, make the same amount of money because one gold future at DGCX in Dubai represents one kilogram of gold. But, and this is the magic of leverage, by purchasing a gold future instead of physical gold you could multiply your profit 32 times.

The difference is this: When you physically buy a kilo of gold you have to pay the full price (about US $21,000) but when you purchase a future you only have to deposit an initial margin (safety deposit) of US $650 (the margin at DGCX).

That is a significant difference and it means that if you have US $21,000 to spend, you can either buy just one kilogram of physical gold or 32 futures (32 times $650 equals $20,800). It also means that if the gold price moves up, your profit from having bought 32 futures will be 32 times higher than it would have been if you had spent your money on physical gold. That's what I call leverage to the max!

But be warned of one thing: whether you bought futures or a physical product, if the price of the underlying value declines, you face a (unrealized) loss. When you bought the future, you only deposited an initial margin of US $650 - now you have to increase this by another amount (variation margin) to meet your guarantee obligation.

By so doing, the credit risk of your opposite party in the contract (the seller of the future) is significantly controlled. Therefore it would not be wise to initially invest in 32 futures and risk a downward move because if you are unable to deposit the variation margin, your position will be liquidated and others will be compelled to take action against you to realize your loss.

Do your homework

Leverage is a great feature of futures and other derivatives like options, but the leverage characteristic demands that you have a full understanding of how these products work, are priced, etc.

It is only by having a full understanding that you will be able to manage the risk of your position, which is especially important when things are not going your way. By being aware of all the pit-falls of derivatives, you will be in a position to discover more advantages.

Apart from leverage, futures offer other advantages over physical assets. One of them is the advantage of easily accessible markets; for example, you can track the index in Korea simply by buying a future on their index. Furthermore, buying futures does away with the problem of having to store commodities: no need to lock gold in your safe or hoard oil in your garden. Good luck with derivatives and their leverage!