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Futures = Leverage - In 2 Minutes

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Futures are referred to as a Leveraged financial instrument. This is a basic concept; but it’s specific meaning and implications are often overlooked. This video quickly reviews this idea . Physical leverage multiplies your output, without a corresponding increase in your efforts. Financial leverage works in a similar manner. With futures contracts, you can control more assets with a relatively small amount of capital. This magnifies both the opportunity; and the risk. Let’s say you want to invest $2,500; and you think that the price of oil is going to rise. If the price of oil is currently $50 per barrel; you could buy 50 barrels with your $2,500. As an alternative to buying the physical asset, you could use the leverage of a futures contract. At the time of this recording, a $2,500 margin deposit would enable you to enter into one oil futures contract. This futures contract would give you exposure to the price change of 1,000 barrels of oil. For the same amount of capital, your gain or loss would be magnified 20-times compared with buying the physical asset. Let’s compare these two scenarios; investing in the physical asset, versus a futures contract. In both situations, our capital commitment is $2,500. We’ll ignore commissions and other costs. If you invest in 50 barrels of oil; a $5 price change will result in a gain or loss of $250. If instead you enter into a futures contract, that same $5 price change will be leveraged into a gain or loss of $5,000. This represents a 200% increase or decrease on your initial $2,500. Futures magnify opportunity; and they magnify risk. Keep this dynamic in mind as you plan your risk management guidelines.
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