Why is Commodity Trading so Profitable and Risky?

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Everyone talks about how futures trading is both very risky and very profitable.  This is very true, but why? It isn't necessarily because of volatility; stock markets are often more volatile. 

Nor, is it because of "evil" speculators manipulating the markets (as uninformed people will tell you.)  Instead, it all has to do with margin and leverage. 

Once again, you will need to clear your mind of any deeply ingrained concepts that you may have about stock trading.  Margin and leverage in futures trading is quite unique and you'll need a clear mind to understand them properly. 

 

First, let's talk about margin...

Margin

Margin is essentially a performance bond, or a 'good faith' deposit.

Margin is the amount of capital that a trader must put forward in order to buy or sell a futures contract.   The amount of margin required for a specific commodity is determined by the exchange and it changes often.  These margin rates are based on many factors, market volatility being the primary one.  Also, margin money is collected by a brokerage house (FCM) rather than the exchange itself.  

Margin money is essentially a performance bond or a 'good faith' deposit.  It is similar to the 'earnest money' that someone would lay down with a serious intention of purchasing a home or other capital purchase. This small amount of margin is all that is required because the full monetary value of the underlying commodity for any futures contract is usually quite large. 

For instance, the CBOT corn contract specifies an amount of 5,000 bushels.  If the market value of corn is $4.00 per bushel, then the total contract value would be $20,000.  This is quite a large amount of money for a trader to forfeit in order to hedge against price risk (remember that futures markets were developed to give producers and consumers a vehicle to hedge against price fluctuations.)   So, the exchanges only require a portion of this total value to be submitted in 'good faith'.  This relatively small amount is all that is required to control and benefit from the entire value of a futures contract.  

Leverage

With this idea of margin in mind it is now easy to see why commodities speculation can be so risky and profitable.  Leverage is the keyword here.  When only a small percentage (usually 5-15%) of a contract's total value is required to control the entire monetary value of a contract, the profits or losses are magnified intensely. In other words, the small amount of margin acts like a lever. 

With a relatively small amount of money, a commodity trader benefits or suffers from the price movements of a much larger sum.  This leverage is the primary reason that commodity futures trading is so profitable and risky.  While a price move in one direction may enormously benefit the trader, likewise, a price move in the opposite direction can seriously devastate the trader's equity.  Thus, leverage is a double-edged sword. 

Still, leverage or no leverage, one might ask why a trader cannot simply hold onto losing positions in the hopes that they will eventually recover.  After all, this is what happens in the stock market.  Yet, when you buy a stock you usually pay the full price for the it and thus there is no leverage involved - you own it completely, 100%.  Although you can buy stock on margin, it is different - you borrow this margin money and are obliged to pay it back. 

This doesn't happen in futures trading.  Trading on margin in the futures markets is not a rarity, it is the way all futures contracts are traded.  Additionally, stocks (in theory) have an unlimited lifespan, but futures contracts have a limited lifespan. 

Leverage is the primary reason that commodity futures trading is so profitable and risky.

Another very important point is that all futures contracts are "marked to market" at the end of every day.  This means that all accounts are settled and matched up by the clearinghouse at the end of every day.  When your contract positions are settled there must be enough capital to maintain proper margin levels.  So, if your account equity has declined due to adverse price movement, then you must add extra money to your account (maintenance margin) in order to maintain the original margin level, or else forfeit your position.  This is a daily reality and it's the main reason that contracts cannot be held indefinitely when they are undergoing losses in value.

Maintenance Margin

Maintenance margin is a percentage of the orignial margin required to open a contract.  Maintenance margin levels are also set by the exchange (usually about 25% under the original margin level) and FCM's are responsible for issuing margin calls if a trader's equity drops below the maintenance level.  If the balance is not collected from the client, the FCM has the authority to offset the position to protect itself, since the FCM is ultimately responsible to the clearinghouse. 

This practice is designed to maintain the integrity of the market, since margin levels are simply 'good faith' deposits.  If traders actually put forward enough capital to cover the entire value of a contract then this would not be an issue. 

A Zero-Sum Game

Commodity trading is a zero-sum game.  This means that when trading positions and their associated profits or losses are tallied at the end of each day (marked to market) the bottom line always comes out to zero.  Every dollar that is lost by one trader is gained by another trader. 

Remember, although most futures traders do not have any intention of producing or receiving the underlying commodity they are trading, the markets must perform as if they intend to do so.  Otherwise, there would be no faith in the futures markets.