Leverage

What Makes Futures Trading So Dangerous…And Very Profitable

Written in 2019 when soybean futures were $9.00


There is hardly an adult in North America who has not heard about the great dangers of “playing the futures market.” I am sure most people would rate trading futures riskier than taking $10,000 to Las Vegas to play the slot machines or at the Black jack tables. Why?


People understand what the slot machines do and how they work. People understand how a Black Jack game works. They know both are rigged against the player and for the house, yet people gamble away billions of dollars every year because theyunderstand and accept the risk in exchange for the opportunity to make money.


If the futures exchanges could do as good a job as the casinos explaining how the futures market work, Las Vegas would go broke because all their customers would trade futures.


Ten years ago, state-run lotteries returned in winnings about 48 cents of every dollar gambled on numbers. They are probably less than that now. Las Vegas casinos returned 98 cents of every dollar gambled to the “winners.” The futures market returns 100% of the money “invested.” For every loser in the futures market, there is an equal winner. Commissions, exchange fees, and taxes take a minuscule percentage of the profits. However, do not confuse trading futures with gambling. Trading futures is an investment or a hedge; gambling is entertainment and hope for good luck. A little brain power will make a lot more money in the futures than it will in a casino.


So, with such a positive return on investment, how did the futures markets get such a terrifying reputation?


Leverage


What is leverage? It is what makes futures trading so dangerous and profitable.


All of us have grabbed a 2-by-4 about 6 feet long and placed a 6-by-6 block of wood 6 inches away from the tongue of a machine, stuck one end of the 2-by-4 under the tongue, and pushed on the opposite end of the 2-by-4 to lift the tongue to match the height of the tractor drawbar. That 2-by-4 gave us leverage to lift a two hundred-pound tongue.


What happened if your hand slipped off the end of that 2-by-4? I am sure all of you have a painful memory of that! And so it is with the leverage in the futures market.


Presently, the initial margin for soybeans at the CBOT is 50 cents a bushel. That means, for a small deposit of just 50 cents, you are in a position to gain or lose the value of the price change of $9 worth of soybeans. That is leverage.


There are two ways to make money on price change of soybeans. One way is to buy or grow cash soybeans for $9.00 a bushel and store them or pay someone to store them. If the price goes up 50 cents, you turned $9.00 into $9.50. Your return on investment is 5.5%. The other way to make money on price change of soybeans is to deposit 50 cents in your futures account and buy soybeans. If the price goes up 50 cents, you made 50 cents. Your commission charge is half of a cent. You made 49.5 cents a bushel. Your return on investment is 99.9%! You doubled your money!


However, we all know the price of beans could drop 50 cents. Your loss in the cash beans would be 5.5% of your investment. That is not good, but it is not the end of the world. Your loss in the futures market would be 100% plus a half cent commission! That might not be the end of the world, but it very well may be the end of your relationship with your broker, your banker and your spouse.


The futures market gives you leverage. If used wisely and carefully, leverage is a valuable tool. If used without extreme caution, it could ruin your life. Just like that 2-by-4 under that tongue. If it gets away from you, you will probably feel some serious pain.


Learn how to use leverage wisely and you can vastly increase the profitability of your farm. Use leverage foolishly, and you can lose your farm.

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