Risk Comparison of Futures with Stocks and Bonds

The volatility of individual futures markets is similar to that of stocks and bonds.  Depending upon the individual market the volatility could be less than that of a U.S. Treasury bond or as volatile as an over the counter growth stock.

The stories one may have heard about investors incurring large losses or making huge gains in the futures markets are usually a result of extremely high leverage and lack of diversification.  Today in the U.S., the margin requirement for stocks in a margin account is 50%.  A $50,000 balance in a margin account will enable the investor to purchase $100,000 of stocks, thus providing leverage of 2 to 1. 

Futures accounts can be leveraged to a far greater degree than the equities. Since a futures contract is simply a legal contract built around the delivery of the product at a future date, the margin deposit is in effect a performance bond to assure that both parties will meet their obligations.  Thus margin requirements are set by the exchanges based primarily on the relative volatility of each market.  As markets become more volatile, the exchanges will generally increase margins and as volatility decreases, the exchanges may lower the margin requirements. 

Following are a few examples of margin requirements as of February 13, 2006.

Market	Contract Value	Margin Requirement	Leverage
S&P 500	$316,425	$19,688	16x
U.S. T-Bond	$112,406	$1,350	83x
Japanese Yen	$106,575	$3,510	30x
Crude Oil	$61,240	$4,725	13x
Gold	$54,210	$2,228	24x
Soybeans	$29,213	$1,148	25x

While individual brokerage firms may impose higher requirements it can easily be seen how extremely high leverage is possible.  As an example one contract of the S&P 500, currently worth $295,000, can be controlled with only $16,875 of margin or approximately 17 to 1 leverage.  Thus a 6% change in the price of the S&P 500 will either double the speculator's money or result in a total loss of the margin deposit. 

On an unleveraged basis the S&P 500 has moved much less than many individual stocks.  However, if one uses significant leverage the percentage moves become much greater.

The other tendency of investors, who trade in the futures markets, is a failure to diversify.  Few investors will put all of their stock market capital into just one or two stocks.  Yet often in a weak moment they will take a "fling" in a single futures market because of hearsay or upon reading a market letter recommendation.  They will put 100% of their futures capital in just one market using maximum leverage.  If they did invest in just one stock and could leverage it 17 to 1, as in our S&P 500 example, they would face the same extreme changes in their net worth as the speculator in our example.

In summary, the primary risks investors are subjected to in futures are due to the excessive leverage available and the failure to diversify.  If one manages the leverage in a prudent fashion and has a diversified portfolio, the risks and return potential can be similar to an equity portfolio.  Furthermore futures, due to their non-correlation characteristics, can offer an attractive diversification to a traditional financial portfolio of stocks and bonds.