A word about leverage

When you buy a futures contract on the Australian stock market index, known as the SPI (pronounced "spy"), you will have to put up a margin of around A$2,500, plus A$25 for each point that the market falls. If the market is currently at 4,000, this means that you are wielding A$100,000-worth of stocks with just A$2,500.

This means you are leveraging your investment by a factor of 40, leaving margin trading in the dust. This is the awesome power of futures trading, and a similar level of leverage applies to most futures contracts. Let's look at what it means in practice...

It means if the market falls just 2.5% you will lose all of your money.

If the market rises just 2.5% you will double your money. Either of these can easily happen in one day.

If the market doubles in value (typically this happens every 3-20 years), your investment of A$2,500 will be worth A$102,500.

If it halves in value (and this also is far from uncommon), you will lose a total of A$50,000 - twenty times your original investment.

This is why you need to be extremely careful not to over-leverage yourself. The more highly leveraged you are, the more likely it is that you will be unable to maintain your position, even if it is a winning position. Remember, the market is constantly oscillating between highs and lows, stopping out over-leveraged traders as it goes, like a grim reaper in ripe corn.

And of course if you are over-leveraged you will be edgy and even prone to waking in the middle of the night with panic attacks, making it virtually impossible to make sensible decisions. To be a successful futures trader, you must strictly limit your greed in order to limit your fear.

 

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