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  • Leverage

     
     

    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.

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