Low Margin & High Leverage Commodity Derivatives

Commodity derivatives are high-risk and high-rewarding financial instruments due to the contract sizes and nature of the commodity markets. Complex factors like climate, the state of the economy and macroeconomic conditions affect the supply and demand for commodities. This makes commodities one of the most volatile asset classes. 

As such, investors and traders require higher leverage and lower margins when trading commodities compared to equities and other assets. One needs to learn the basics about derivatives, such as margin, leverage, etc., before trading.

In this blog, we will learn about low-margin and high-leverage commodity derivatives and their pros and cons.

What Is the Meaning of Margin?

Margin is the minimal sum of money a trader must have on hand to purchase or invest in any commodity. Investors need to deposit the margin amount to their stockbrokers to get a loan from them for trading assets like commodities. In commodity trading, brokers offer lower margin requirements allowing traders to make bulk orders.

Before beginning to trade in commodities, it is vital to have a solid understanding of a variety of characteristics, including the initial margin and maintenance margin. Below is a description of these terms.

• Initial Margin: To purchase on margin, an investor must first create a margin account and put up a small down payment. The minimal margin is the amount that allows a trader to get leverage.
• Maintenance Margin: Maintenance margin is the subsequent margin that must be periodically deposited into the margin account to continue trading on leverage. Thus, maintenance margin can be viewed as the initial margin’s follow-on secondary stage margin. 
• Margin Call: The broker will issue a margin call if the total value of the position falls below a specified limit. Then, it will ask you to either deposit additional cash or repay the entire loan with the remaining money, or by selling off your investment.

What Is the Meaning of Leverage in Trading?

While learning about commodity derivatives with high leverage, it is crucial to know about leverage trading. Leverage is the facility used to borrow cash to finance the trading of various assets and amplify future returns. 

In simple words, leverage is the ratio of money invested and the amount of funds allowed to trade after taking the loan. It involves depositing a certain sum of money, called a margin to increase exposure to an asset. Leverage can be considered an overdraft facility for trading, and it is offered by numerous brokers.

Traders use leverage to increase their investment returns in shares, commodities, futures and options. On the other hand, companies use it to finance significant operations and increase the value of their equity.

You can avail between 5 to 100 times your available capital on your Demat account by using leverage facilities. For instance, if you have ₹10,000 in your account, you can trade between ₹50,000 to ₹1,00,000 in commodity derivatives using leverage.

This may seem very lucrative; however, leverage comes with pros and cons. It magnifies the effect of losses as much as it increases potential returns. So, traders are recommended to apply risk management measures like stop losses and limiting leverage. 

Margin Trading in Commodities

You can create a margin account to start trading in commodity derivatives on commodity exchanges such as the Multi Commodity Exchange of India (MCX). There is a wide range of low-margin and high-leverage commodity derivatives available in such exchanges. Margin requirements in commodity derivatives range from 3% to 5%, which are much lower than for equities.

Using leverage, you can gain a significant position in commodity derivatives. While it can help earn massive gains, it could also lead to a similar level of losses due to your significant exposure and the volatility of commodities.

Advantages and Disadvantages of Margin Trading

The advantages and disadvantages of margin trading are listed below.

Advantages

• Increased Purchasing Power: Instead of purchasing securities with your own money, you can use considerably larger capital with little collateral. Hence, you can easily deal with bulk trade of commodity derivatives.
• Amplified Profits: With a more significant amount of securities in hand, the profits can increase significantly since you are heavily invested using debt.
• Further Leverage Opportunities: If the value of the collateral increases, you may be able to utilise additional leverage to increase your position further. 
• Flexibility: Margin trading offers more flexibility than other kinds of loans. There is a lack of fixed repayment schedules and brokerages can automate their fees.

Disadvantages

• Amplified Losses: Just like margin trading can amplify gains; it could similarly amplify losses, leaving investors burdened with unsustainable positions and additional expenses.
• Account Fees and Interest: Margin trading comes with interest expenses charged by brokers. These fees are constant, regardless of how your portfolio is performing.
• Margin Call: Your broker can issue a margin call in your name. This would require you to pledge an asset as a security deposit to cover any losses. In this case, your broker may ask you to deposit a higher margin.
• Forced Liquidation: If the value of your account drops fast and does not fulfil margin requirements, a forced liquidation may occur to meet the brokerage requirements.

Advantages and Disadvantages of Leverage Trading

It is crucial to know the pros and cons of leverage, and they are listed below.

Advantages

• Lower Capital Requirements: Leverage allows you to take more significant positions in the market without heavy capital requirements. It helps make huge profits if the trade goes well and enables investors with low capital to enter the market.
• Greater Exposure: Leverage allows you to have greater exposure in the index whose derivative you are planning to invest in. Hence, you do not have to restrict your call or put option due to a shortage of funds.
• Chance to Earn Massive Profits: One of the greatest advantages of leverage is that it enables investors to enjoy increased profits.

Disadvantages

• Potential for Significant Losses: While leverage can help increase profits, it is a double-edged sword. Hence, if the trade does not go well, it could result in huge losses, which could have been prevented by not availing of leverage facilities.
• Cost vs Benefits: The cost of continuing could exceed the benefit if the position you hold is long term. Hence, you should use leverage for short-term trades instead of long term ones.

Commodity Derivatives vs. Equity Derivatives

Let us understand the leverage and margin facilities of commodity derivatives by drawing a comparison with equity derivatives below.

Table 1: Equity Derivatives vs. Commodity Derivatives

*Source: NSE & MCX

Margin Requirement may vary as per Exchange Requirement

In the above table, we can observe that the Gold 1 KG Futures contract size is larger than that of NIFTY50 Futures. However, Gold 1 KG Futures requires a lesser margin of 8% as compared to NIFTY50’s margin of 12%. Hence, the commodity contract holds higher leverage with a more favourable price movement to give higher returns.

Table 2: Impact of Leverage

*Source: NSE & MCX

*Margin Requirement may vary as per Exchange Requirement

From table 2, we can see that commodity derivatives have significantly higher returns for even a 1% price movement due to high leverage. However, high leverage is a double-edged sword which could also lead to a significant loss.

Final Word

Several experienced and well-known traders use margin accounts for leverage. However, newbie traders should be careful against using leveraging tactics until they have a clear understanding of the functioning of the commodity market. Low-margin and high-leverage commodity derivatives are excellent trading options which can assist in tremendous gains.

Frequently Asked Questions