Leverageis a significant characteristic of the
futures market. In light of coffee
price volatility, it is important to be aware that futures contracts are leveraged instruments, meaning that a trader does
not pay the full market price for each contract.
Instead, futures traders pay a small portion of the
contract's total value (usually less than 10%) in the form of margin, a good
faith deposit to ensure contract performance. A New York arabica 'C' contract
trading at 100 cts/lb would be worth $37,500 (each contract is for 37,500 lb of
coffee). If the margin requirement is about US$ 3,000 dollars per contract,
buying 10 contracts at 100 cts/lb means posting a margin of US$ 30,000,
representing a long (unsold) position worth US$ 375,000.
Leverage offers
advantages, but it carries an equal amount of risk. If the market moves down 10
cents before a selling trade can be achieved then the loss of US$ 37,500 in this
case represents 125% of the original investment of US$ 30,000 and will require
payment of a variation margin (see later in this chapter). Of course the hedger
would be realizing a comparable gain in the cash market of the value of the
planned physical transaction.
Large margin calls
(additional payments necessary to maintain the original margin level) sometimes
further increase volatility when inability or unwillingness to raise the
additional deposits causes traders or speculators to liquidate their positions,
thus fuelling the price movement up or down still further.