The Dangers of Leveraged Investing/Trading: Futures Contracts 

NOTE: This post is Part 3 of The Dangers of Leveraged Investing/Trading series. You can check out the other posts here.

Leveraged investing and trading can be extremely profitable, but it’s also fraught with risk. One of the methods used to do that is through futures contracts.

When successful, futures contracts can provide a way to amplify returns. However, when things go wrong, futures contracts can lead to devastating losses.

In this article, we’ll explore the dangers of leveraged investing and trading in futures contracts.

What Are Futures Contracts?

In my previous post about CFDs, I previously mentioned that CFDs are a ‘derivative’ of stocks, and that it’s basically a contract that allows you to profit from stock price movements without actually owning the stock.

Futures are also contracts, and can be set up as derivatives not only for stocks, but also a wide range of other items such as oil, gold, cotton, currencies and even indexes. All these different types of futures work the same way, and for the sake of simplicity in our explanations, we’re going to focus on explaining futures contracts of stocks.

Essentially, futures contracts are a legal agreement to buy or sell a particular stock at a predetermined price at a specific time in the future.

It started as a way for businesses to protect themselves from price volatility by locking prices of raw goods for the future. An example of this is a cheese factory that locks in the price of milk for the future in case milk prices rise in the future for whatever reason – such as a shortage of cows.

But soon investors found they could profit from these contracts by speculating price movements in the future and purchasing these contracts in hopes that they could either buy at a cheaper predetermined price and sell high at that set date, or buy a cheaper price and sell at a higher predetermined price at that set date in order to profit.

Why People Are Drawn Towards Futures Contracts Like Moths To A Hot Flame

Like CFDs and Forex, people are also attracted to trading Futures contracts because of the potential to leverage. They typically have a margin rate of 10%, meaning you can borrow 10 times your initial capital.

If we are to continue with our previous example of Person X with a limited portfolio of $1,000, they can expose themselves to $10,000 worth of stocks.

Let’s say that $10,000 portfolio increases in value by 7% and Person X decides to sell out, that would result in a return of $700 (disregarding fees and other costs).

If we were to compare that $700 return against the initial $1,000, that would be a 70% return – much higher than Warren Buffett’s average 20% annual return.

Sounds pretty cool right? After all, Person X has managed to beat the world’s most famous investor.

Why Futures Contracts Are Dangerous

Now let’s flip that around. If Person X’s $10,000 Futures portfolio decreased by 7% instead, that would result in a loss of $700, resulting in a net of $300 after deducting from the $1,000 starting capital.

In this case, Person X would not receive a margin call as their account is still in the positive, but they have effectively lost 30% of their portfolio.

Again, while you can magnify your wins, you can also greatly magnify your losses and lose your entire account with one wrong trade.

Now you might think “Hey, that’s not so bad. 30% isn’t as bad as being in the negative and receiving a margin call like we’ve seen in previous types of leverage.”

But it takes a 42.9% gain in order to recover from a 30% loss.

The world’s best fund managers achieve between 15-30% per year on average, and that’s with the help of good trading systems and teams of full-time financial analysts.

So aiming to get 42.9% back is ambitious.

The Gambler’s Mindset

Now, you might say Person X could recover that loss by taking on leverage again – “after all, one winning leveraged trade could easily wipe the slate clean, right?

If you’re thinking that, then you’re already in dangerous territory and at risk of dealing more harm to yourself – because that’s exactly how most gamblers think.

The more you lose, the more you’ll need to gain back to recover your losses, so with that mindset you’ll keep taking leveraged positions again and again, and the cycle repeats itself as rabbit hole only gets deeper and deeper.

A lot of the time I get approached by people who have gone through these cycles too many times, and they ask me I can rescue them from the pit they’ve dug themselves into.

My answer is for them to cut their losses and simply start again. I understand it’s difficult to let go of psychologically, however it was that thinking that got them into that situation in the first place.

Extra Risk – Forced to Buy or Sell at a Predetermined Price (Locked In)

Another risk for Futures is the lack of adaptability due to the nature of the contract, where you must either buy or sell at the listed predetermined price at the set date.

In other words, futures contracts make your investment and trading strategy highly inflexible.

Unlike normal stock purchases where you have the choice to either hold on, take another position, or execute a stop loss when things don’t turn out the way you expect, with futures contracts you are forced to execute the order listed on the contract and take a loss if things don’t work out.

There is the option of selling your Futures contract to someone else before the settlement date, however, you’d have to find someone willing to purchase it, which only becomes more and more unlikely the closer you get to the settlement date.

Summary

So as you can see, in addition to the risk of taking a big loss with just one wrong trade due to leverage that you can’t recover from, trading Futures can also make your investment and trading strategy inflexible.

The next time you hear a friend or a family mention Futures as part of their investing and trading, have a conversation with them about it to make sure they really understand what they’re getting into…

At the end of the day, it’s entirely up to you to make the decision, however, all of the above reasons are why I choose not to participate in Futures trading.

Hopefully this post will help educate your friends and family on what’s really involved when it comes to Futures trading.

Terry

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