One way to increase efficiency is by using financial instruments like futures. These allow you to control big positions with small amounts of capital, thanks to leverage.
Leverage and Capital Efficiency
Futures contracts allow you to control big positions with small capital. You only need to post a margin which is a small fraction of the notional value to enter a position. For example if you wanted to buy an E-mini S&P 500 futures contract you might only need a maintenance margin of $5,000 with discount futures brokers, even though the contract itself has a notional value of $260,000 (5,200 value ES contract * $50 value per point).
Leverage in futures trading means your initial margin controls a much bigger position. This can be a powerful tool for increasing capital efficiency. For example buying 50 shares of the SPY ETF at $520 per share would cost you $26,000. But buying one E-mini S&P 500 futures contract requires much lower margin (about $5,000 but it depends on the broker) so you can potentially achieve similar gains with less upfront capital.
You need to keep a maintenance margin in your futures account to hold your positions. If your account equity drops below a certain level due to adverse price movements in the underlying asset you need to add margin or reduce your position. This daily adjustment is done through a process called mark to market.
Equity Margin vs. Futures Margin
You have $100,000 to invest in a broad based basket of stocks like the S&P 500 index (SPX) you have several options:
- Buying shares with cash (with a cash account)
- Buying shares on margin (with a margin account)
- Buying E-mini S&P 500 futures (ES) (with a margin account and futures trading approval)
Investing With Cash
If you buy shares with cash you can only buy as much stock as your money allows. For example if the SPY is trading at $520 per share:
- $100,000 / $520 per share = approximately 192 shares
This means your entire $100,000 is tied up in 192 shares.
Buying Shares on Margin
When you buy shares on margin you can buy more shares by borrowing money from your broker. If you have a 50% margin (overnight) you can use this to buy 384 shares at $520 per share:
- Money Needed: 384 shares * $520 per share = $199,680
- At 50% margin: $199,680 * 0.50 = $99,840
This means you need $99,840 from your capital, plus you need to cover transaction costs and pay interest on the borrowed money. Margin can give you more buying power but comes with the cost of interest and ties up a big chunk of your portfolio.
Buying E-mini S&P 500 Futures
The E-mini S&P 500 futures contract is another option. Each contract has a notional size of $50. To see how this works:
- If the S&P 500 is at 5,200 then:
- Notional value = $50 * 5,200 = $260,000 per contract
With futures you only need to put up a fraction of the notional value as margin. The margin requirements vary and typically range from 2% to 12%. If we assume 5% margin:
- Margin needed = Notional value 5% = $260,000 0.05 = $13,000
This means you get more exposure by owning 384 shares of the S&P 500 index but you only need $13,000 in margin rather than using up a big chunk of your capital. Using futures allows you to manage your capital more efficiently, get the same market exposure without the need for full upfront investment or borrowing costs.
Margin Trading in Futures
Margin trading in futures is very different from margin trading in equities. In futures margin is a good-faith deposit, not a loan, so you can open and maintain a position. This amount is held by your broker to cover potential losses and no interest is charged.
In futures trading margin requirements vary by contract. For example the E-mini Nasdaq-100 has a different initial margin than the E-mini S&P 500.
When trading on margin in the futures market the concept of leverage is key. Leverage allows you to control a big position with a small amount of money. But higher leverage means higher risk. Even small market movements can lead to big losses and there may be additional margin calls to hold your position.
Margin Benefits in Futures Markets
- No Interest: Since margin is not a loan, there is no interest cost to hold a futures position.
- Leverage: Maximise capital efficiency by controlling a bigger position with a smaller amount of money.
- Flexibility: You get to keep more capital to use for other investments or to hold other positions.
Risks of Margin in Futures Markets
- Potential for Big Losses: Due to the high leverage, even small market movements can lead to big losses.
- Margin Calls: If your account balance goes below the maintenance margin you will need to deposit more funds to keep the position open.
- Immediate Liquidation: Your broker may liquidate your position without notice if you don’t meet the margin requirements.
