Leverage a Position while Day Trading in Futures
A futures contract gives a day trader the obligation to buy or sell an underlying financial instrument (stock, bond) or agricultural commodity, assuming you still hold the contract at the expiration date.
The underlying product can be anything from treasury bonds to barrels of oil and heads of cattle, and you’re only putting money down now when you purchase the contract. You don’t have to come up with the full amount until the contract comes due — and almost all options and futures traders close out their trades long before the contract expiration date.
Although most options and futures contracts settle with cash long before the due date, contract holders have the right to hold them until the due date and, in the case of options on common stock and agricultural derivatives, demand physical delivery.
It’s rare, but the commodity exchanges have systems in place for determining the transport, specifications, and delivery of grain, cattle, or ethanol. One advantage of day trading is that you close out the same day, without ever even thinking about the fine print of physical delivery.
Because derivatives have built-in leverage that allows a trader to have big market exposure for relatively few dollars up front, they’ve become popular with day traders.
Here’s how derivative leverage works: a trader is buying the Chicago Mercantile Exchange’s E-mini S&P 500 futures contract, which gives her exposure to the performance of the Standard and Poor’s 500 Index, a standard measure of the stock performance of a diversified list of 500 large American companies.
The futures contract trades at 50 times the value of the index, rounded to the nearest $0.25. The minimum margin that this trader must put down on the contract is $3,500. Each $0.25 change in the index leads to a $12.50 ($0.25 × 50) change in the value of the contract, and that $12.50 is added to or subtracted from the $3,500 margin.
Some exchanges use the term margin, and others prefer to use performance bond. Either term refers to the same thing: money you put in up front to ensure that you can meet the contract terms when it comes due. If you hold the contract overnight, your account is adjusted up or down to reflect the day’s profits. If it gets too low, you’re asked to add more money.