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Leveraging In Commodity Trading

The concept of leveraging in commodity trading has a broadly similar effect to that achieved trading stocks and shares.

Initial margins on commodities are generally much lower as a percentage of the value of the futures contract than a contract in shares.

It is not unusual to see margins as low as 3%, with the range up to 15% and this is what generates significant leverage when trading commodities.

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So it is not surprising that many potential commodity traders get excited about the ability to control large futures contracts with a small “deposit” or investment of capital.

For example, let’s say the initial margin for a non-member customer is $12,500 to trade light, sweet crude oil on NYMEX.

So with crude oil around $100, and given that one contract represents 1,000 barrels, the trader would control $100,000 of crude oil for the above margin. In other words the leverage here is 12.5% or roughly 8 to 1.

Let’s say that a trader decides to go long Dec 08 crude oil when it is $100, then she would be expecting the price to rise from this point.

One week later, for example, let’s assume the recent $700 bn Paulson bailout plan seems to be easing the anxiety in the financial markets and contributing to some recovery in confidence and economic activity.

The markets are more bullish on crude oil as they believe the demand will pick up again with this rising confidence.

There is also the approach of winter and OPEC announces that it will keep its production levels unchanged.

All these factors, for this example, would cause the price of West Texas Intermediate crude oil futures on NYMEX to rise to $115.

At that point our trader is sitting on a Dec 08 crude oil futures contract with a value of:

$115 x 1,000 barrels = $115,000

If she would now decide, after a week in the market, to liquidate this position, she would generate a profit of $15,000 (115,000 – 100,000) (excluding any transaction costs).

So, just by putting up $12,500 she has used the power of leveraging in commodity trading to turn that contract decision into a $15,000 gain within one week. This is a 120% return on capital (ROC) in 7 days.

This is the power of leverage in commodity trading, a 120% gain to the trader, even though the price of crude oil only went up 15%.

What if the market goes the other way?

Remember, however, if the oil market did not react favourably to the Paulson plan, crude oil futures could have dived, let’s say to $92.50 over the same 7 day period.

Now our commodity trader who went long crude oil is not so happy. Of course, others in the market who expected crude oil to fall may go short oil, and they would be happy at this point.

Why? Because the account is making a loss and she is likely to receive a margin call to re-establish the maintenance margin. If she decided to cut her losses and liquidate her position, the result would be:

Buy 1,000 barrels (1 contract) @$100 = 100,000; Sell 1,000 barrels @$92.50 = $92,500 Loss = $7,500

Here the trader has made a loss of $7,500 and this represents a 60% reduction in original capital (initial margin) when the price of crude oil only fell 7.5%.

Here again is the power of leveraging in commodity trading, only this time it has created a loss of capital.

Clearly the combination of derivatives and leveraging can make spectacular profits but equally major losses if the market goes the opposite way to the trader’s position.

Leveraging can make the ride more volatile as it exaggerates small movements in the price action when transmitted to the value of futures contracts.