Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
$30,500. Buy ten of those and you would have to pay $305,000. Other contracts such as some financial-based ones could go as high as $1 million.Who can afford dealing in such expensive instruments?
Enter the power of margin and leverage. Many years ago I used to hear a radio commercial inviting the listeners to make money by controlling $40,000 worth of gold with just $2,000. I couldn't understand how and what they meant by control. Turns out that they were talking about leverage. Here is how it works.
Let's just continue using our gold example. When a trader buys or sells a contract she is obligated to deposit an initial amount of money, known as initial margin, equal to a percentage of the contract's worth into his account. The initial margin may be between 1% to 20% of the price of the contract, and it binds the trader to the contract. For example, if you are interested in buying ten gold contracts maturing three months from now and priced at $310/oz., you may be obligated to deposit $6,200 into your account to initiate the purchase, based on a 2% initial margin:
10 contracts x 100 oz./contract x $310/oz. x 2% = $6,200
There it is. With just $6,200, you are in control of 1,000 ounces of gold and you are hoping that gold prices will start moving up so you can have a profit. That is leverage.
Once you have obtained your contracts, your account must continue to be worth a minimum amount in order to guard against potential losses in your contracts. The minimum maintenance amount may be less than the initial margin (let's say $5,000) but it assures the broker (who is responsible for those contracts as your agent) that you can cover your losses should the contracts erode in value due to price drops …
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