Leverage and Commodities Trading - The Basic Terminology

Commodities trading, like any other commodity trading, utilize a principle called "leverage" to expand the reach of the investor. Much like mechanical leverage in your old physics class, financial leverage is about multiplying the amount of motion you get from the energy you put into a transaction.

How it works is like this: Instead of ponying up $10,000 of your own money to make a commodities trade, you put up about $500 (1/20th of the amount purchased), and borrow the remaining $9,500. Let's say that your trade shifts by 10 basis points between the price you purchased the commodity at and the price you sold it at; you've made a $10,000 purchase and sold it for $10,100, making a $100 profit on the transaction. Now, you will have to pay back the $9,500 you made, plus some interest on the loan. Let's assume that the interest is 9% per year, and that you made the margin purchase and sale in a 24-hour period. If you held on to the $9,500 for an entire year, you would have to pay $855 in interest.

Since you only held on to it for one day, you pay $855/365=$2.35 in interest on it. Your net profit on your $500 investment is $100 (the profit from the transaction) minus the interest on the money you used for leverage ($2.35), or about $97.65, which is about a 19.5% rate of return in one day. Margin trades are the fundamental tool of the trade of the day trader in commodities trading. They're also useful for position traders to magnify their leverage on a market, particularly if they can get a good rate on the interest they're paying on their margin run.

Let's say you make a trade that goes up, but you think it has farther to go; you can make an informed decision about how far up you're willing to wait, or what signals you're waiting for, and just pay the daily interest and fee on the money you borrowed for the margin run. Yes, it'll eat into your profit, but it can be used to play a bet long rather than frantically watching for every possible blip in the market. Leverage and margin are useful tools, but going back to the analogy from physics, they can be dangerous ones. Most trading houses will have a margin ratio - this is how many of your own dollars you have to put in for each dollar of leverage you get to exert.

The reason for this is that many trade choices don't pan out, and a call to pay back the money (a margin call) can cause an entire network of trades to go under if you default. (As an historical aside, most of the stock market and commodities and futures market horror stories in circulation were magnified by margin calls and leverage gone bad.) If you're serious about commodity trading as your job, and by serious, we mean willing to work 9 to 10 hours a day on it at odd hours of the night; leverage and margin are tools you should know. If you're just dabbling in it, trade commodities markets with a position trading strategy instead, and keep your margin ratios sane.

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