The Benefits of Futures Trading Using Leverage and Margin
In order to gain a better understanding of a futures contract, let’s review specifically how leverage and margin are used in a typical futures transaction.
Over the course of the past 30 years, Wall Street bankers and financial professionals have created a laundry list of new products for the investment community. These days, there is an “alphabet soup” full of new investment vehicles. Despite the growing assortment of new innovations, each of these products have one thing in common: they can all be placed in one of four different investment categories: stocks, bonds, commodities, and cash.
Without question, the category that provides the greatest amount of volatility is commodities (also referred to as real assets). This category is designed for investors who are searching for a high degree of volatility, in exchange for a large potential rate of return. Historically, commodities have certainly lived up to their reputation as a highly speculative asset class.
The major contributing factor to the volatile nature of commodities is based on the fact that most investors trade commodities through a futures contract. These contracts are created to provide the maximum level of speculation for traders who prefer to participate in this highly volatile environment.
Leverage and Margin
Why do futures contracts contain so much erratic price behavior? Because the contracts have a high degree of leverage, which can turn a small price movement into a substantial profit or loss. In order to gain a better understanding of a futures contract, let’s review specifically how leverage and margin are used in a typical futures transaction.
As an example, let’s assume that you are bullish on the price of silver. In other words, you expect silver to rise in value. Purchasing a silver futures contract would allow you to realize a nice profit if your bullish analysis is correct.
The futures exchange offers a silver contract with a unit value of 5,000 ounces. Essentially, if you purchase the contract, you own 5,000 ounces of silver. The current price is $15.25 per ounce. Therefore, you own $76,250 worth of silver (5,000 x 15.25). Most investment vehicles would require the investor to deposit the full value of the underlying asset. In this case, the amount would be $76,250. However, you purchased a futures contract, which is a leveraged transaction. Consequently, you are not required to pay 100% of the contract’s value.
In regard to the silver contract, the futures exchange requires a small “good faith deposit” (i.e. margin requirement) of $4,400. In effect, you own $76,250 worth of silver for only $4,400. This is an example of leverage. As you can see from the silver example, leverage allows you to own a considerable amount of a specific commodity with a very small amount of money.
As a trader and investor, you should always remember that leverage is a double-edged sword. If you participate in a leveraged investment and it moves in your favor, you will enjoy a substantial rate of return. Conversely, if your leveraged investment moves against you, the losses will be magnified. It works both ways.
CME BTC Contract (Leverage and Margin)
Very briefly, let’s review the leverage and margin requirements of the CME Bitcoin (BTC) futures contract. The contract unit of CME BTC is 5 Bitcoins. Let’s take the current value of Bitcoin as $6,450. Therefore, the value of the contract is $32,250 (6,450 x 5). The CME BTC margin requirement is equal to 43% of the contract’s value (multiplied by 110%). For example, 43% of $32,250 is $13,867. 110% of $13,867 is $15,254. Therefore, the margin requirement is $15,254. This is the amount of money required to control one BTC futures contract.
Essentially, if you want to trade a single BTC futures contract, you must have $15,254 in your futures account at all times.
Digitex BTC/USD Contract (Leverage and Margin)
The Digitex Futures Exchange offers its own Bitcoin contract. Before we review the margin specifications of the Digitex contract, let’s discuss the DGTX token. What is DGTX? It is the native cryptocurrency used exclusively by the Digitex Futures Exchange. Digitex is a very unique futures exchange based on the fact that it is the only exchange with its own native cryptocurrency.
DGTX tokens are used to cover the margin requirement for the Digitex BTC/USD contract. Specifically, the BTC/USD margin requirement is whatever the trader wishes it to be. Traders can choose their desired leverage anywhere between 5x to 100x, which means they must post margin equivalent to between 1% and 20% of the value of the futures contract. The value of the Bitcoin futures contract on Digitex is calculated by dividing the quote price by the tick size and then multiplying that by the tick value of 1 DGTX. In dollar terms, it depends on the value of DGTX at the time of the transaction. For example, let’s assume the current price of DGTX is $0.15 and the trader wants 20x leverage. Therefore, in dollar terms, the BTC/USD margin would be $9.68:
$6,450 / $5 = 1,290 Ticks
1,290 Ticks / 20x Leverage = 64.5 Ticks
64.5 Ticks x 1 DGTX = 64.5 DGTX Margin
64.5 DGTX x $0.15 = $9.68
Comparison Between CME and Digitex
As you know, both exchanges offer their own Bitcoin futures contract. However, the contracts are vastly different in terms of margin and leverage. Which exchange offers “more bang for your buck”? Let’s review the details along with a few specific examples.
In regard to margin requirements, the CME BTC contract is definitely more onerous than the Digitex BTC/USD contract. As we discussed earlier, the CME requires its customers to shell out 43% of the BTC contract value (multiplied by 110%). Quite honestly, most small and mid-sized futures traders can’t afford to meet the margin requirement of the CME contract. In comparison to the CME contract, the Digitex contract is certainly more appealing to the futures trading community.
Let’s review a specific example by comparing the activity of two different traders. Mary and Jane are both cryptocurrency traders. However, Mary places her trades through the CME, while Jane uses the Digitex Futures Exchange. Both traders are bullish on the price of Bitcoin, expecting higher prices. With the price of BTC trading at $6450, they decide to purchase 1 futures contract.
Mary purchases 1 CME BTC contract at the current price of $6450. The CME margin requirement is $15,254 per contract. Jane purchases 1 contract on the Digitex exchange. Her purchase price is $6450, the same as Mary’s. However, Jane’s margin requirement is vastly different than Mary’s. Jane chooses a Leverage Rate of 20x and so is required to deposit 64.5 DGTX tokens per contract.
As an active futures trader, would you rather deposit $15,254 in your account or 64.5 DGTX tokens? The answer is obvious. Adam Todd and his team at Digitex are constantly working to improve all aspects of the Digitex exchange to provide a great trading experience for the smaller futures traders who cannot afford the high margins and high trading costs of using traditional futures markets like CME.
In my humble opinion, the CME BTC contract is entirely too large. Most likely, it was designed for institutional traders to be used as a hedging device in order to cover their cryptocurrency exposure. This contract is not very user-friendly for the average retail futures trader. In reality, very few traders can financially afford $15,254 to cover the margin requirement for a single futures contract. Even if a trader has a substantial account balance, does the trader really want to allocate almost $16,000 of her/his account balance for a single trade? Most likely, the answer is “No”.
As an active futures trader for 29 years, I can honestly say that I’ve never seen anything like the Digitex Futures Exchange. In regard to blockchain technology, Digitex is truly a pioneer within the futures industry. They are clearly ahead of the CME in terms of implementing the blockchain into their futures exchange platform. The CME is still locked in the past, clinging to an outdated exchange/broker business model that will soon be extinct. Conversely, Digitex is leading the way forward in the 21st century by embracing new and innovative technology. Now is a great time to join the Digitex community as it prepares to launch its futures exchange in the fourth quarter.
Brief Summary of Leverage and Margin in Futures Trading
- All investments can be placed in one of four categories (stocks, bonds, commodities, cash).
- Commodities contain the greatest amount of volatility.
- The volatility is enhanced by the use of commodity futures contracts.
- Futures contracts allow traders to leverage their position.
- The margin requirement for CME BTC is 43% of the contract’s value (multiplied by 110%).
- Traders on Digitex can select their desired margin requirement between 1% to 20% of the contract’s value.
- All margin requirements on the Digitex Futures Exchange must be posted in DGTX tokens, which creates demand from traders.
- In regard to leverage and margin, Digitex offers a far more accessible product to smaller traders versus the CME.