4. Built-in leverage: where almost every accident comes from

Derivatives 1: Futures

If you had to keep one single idea from this level, it would be this: in a future, leverage is not a feature you switch on or a loan you take out. It comes inside the contract, from the factory, and it is there from the first second even though you have done nothing to summon it.

The leverage comes inside the contract

When you buy shares outright, leveraging yourself requires a deliberate act: taking out a loan, signing up to a margin account, accepting terms. You notice it.

In a future there is no deliberate act at all. You deposit margin that is a small fraction of the contract's value and you end up exposed to the full value. That margin is not the price of anything: it is a solvency bond. Treating the deposit as if it were your investment is where most derivatives accidents begin.

How much notional you control per euro, and what move wipes you out

Let us go back to the contract from the first module. Multiplier of 50 euros a point, index at 5,000: notional of 250,000 euros. Initial margin, of the order of 20,000 euros.

• Leverage: 250,000 divided by 20,000, that is, 12.5 times. Every euro of margin moves twelve and a half euros of real exposure.
• A 1% move: 50 points, or 2,500 euros, 12.5% of your deposit. A quiet day in the index is an eventful day in your account.
• A 3% move against you: 7,500 euros of loss, 37.5% of the margin. You have 12,500 left and you are well below any maintenance threshold.
• The move that wipes you out: 20,000 over 250,000, 8%. A fall like that is nothing exceptional in the history of stock markets and it consumes the entire deposit.

And there is a detail that arithmetic does not capture: beyond 8% you are not left at zero, you are left in the red, owing money. With a share the worst that can happen to you is to lose what you invested; with a future, no.

The margin call and forced liquidation

The real sequence is this. Daily settlement takes the day's losses away from you. If the balance drops below the maintenance level you get a margin call, which is a demand, not a suggestion. The deadline tends to be short, often the same day, and in episodes of stress brokers shorten it and raise the margin required.

If you do not top up, your position is closed at market. And there lies the cruel feature: forced liquidation arrives at the worst possible moment, when the price has already moved against you, the spread has widened and thousands of similar positions are being closed at the same time, pushing the price further away. You do not choose when to get out: your balance chooses for you.

And something that often goes unnoticed: margin requirements are not fixed. When volatility rises, the clearing house raises them, and you can be hit with a demand for money without having lost a euro that day.

Count the risk on the notional, not on the margin

Out of all this comes a rule of mental hygiene worth more than any technique:

• Your exposure is the notional, not the margin. If you have deposited 20,000 euros and control 250,000, you are invested to the tune of 250,000.
• Leverage can be neutralized. If you leave the remaining 230,000 in Treasury bills, your position behaves like an outright purchase and you can meet the calls without selling anything. That is a fully collateralized position.
• Size is decided before you go in, by working out how much you lose if the underlying moves 5% or 10%, not by how much margin fits in your account. Choosing it by what the broker allows you is leveraging yourself without knowing it.

A real case: Metallgesellschaft, 1993

The American subsidiary of the German group Metallgesellschaft had sold fixed-price fuel supply contracts with terms of up to ten years. So as not to be exposed to a rise in oil, it hedged those commitments by buying short-dated futures which it rolled month by month.

In 1993 the price of oil fell sharply. The hedge worked in the expected direction: the supply contracts became far more valuable, because it was selling at a fixed price above the market. But that gain was paper to be collected over years, while the loss on the futures was paid in cash every night.

On top of that, the market moved into contango, and each roll added a cost to the bleeding. The position was enormous and the margin calls consumed liquidity the company did not have. The parent decided to close the positions, and the realized losses were put at around one billion three hundred million dollars, the figure usually cited in the literature.

There is still academic debate about whether the mistake lay in closing it or in the design. The lesson is the same under either reading: a position can be right about the price and still die for want of cash. Leverage does not kill you because you got the direction wrong; it kills you because it forces you to prove your solvency every day before time proves you right.

What you take away from this level

• A future is a standardized contract with a clearing house in the middle; that clearing house does not erase risk, it concentrates and mutualizes it.
• The price of a future is spot plus cost of carry minus the asset's income. It is not a forecast, and reading it as one leads to bad decisions.
• The basis converges at expiry because the time left to fund runs out; arbitrage holds it in place as long as it can be executed.
• Rolling in contango erodes capital year after year even though the spot price does not fall.
• Leverage comes inside the contract: always measure on the notional and decide the size before you go in.

All of this is education, not an invitation to trade futures. They are legitimate instruments, designed to transfer risk rather than to multiply it. What decides whether they are a tool or a trap is not the contract, but the size you choose.