Ever wonder why you hear about so many fortunes being made and lost in the futures markets? Here is the answer "Leverage"! Let's look at this double-edged sword that we all live by each day of our trading careers.

Suppose that you are in the camp that believes inflation will be on a rebound in the future. After all, just look at how much money our government pumped into the financial system. Then, look at the international central banks and note the amount of liquidity they have been injecting into the banking systems.

In our country, the Fed Funds rate is extremely low, making funds readily available and cheap at the same time. Does anyone remember the interventions from central banks from the aftermath of 9/11? I have attached a Gold chart showing the 2001 low in Gold. Now that all this new money coming into the economy has found its way through the system and into the markets, we have the makings of a bull move in Gold due to higher inflation.

So, you decide that your portfolio may need some protection (hedge) from this inflation. You decide to buy some Gold. The question is: How do you get the best return on your investment?

Gold Chart

Most people don't have $81,000 to purchase 100 Troy ounces of Gold. The current market price for Gold (as of the first writing of this article in 2008) is $810 per Troy ounce. You have some options here. You could purchase the Gold in the cash market or purchase a futures contract (100 Troy ounces is the contract size). If you purchase the futures contract, you would only have to put up $7,425 to control $81,000 worth of Gold – approximately a 9 percent investment.

This 9 percent is referred to as "initial margin". The amount is subject to change on a daily basis. It is set by the exchanges and brokerage firms based on market volatility and other factors affecting price risk. The exchanges set the minimum amount you can invest with. Some brokerages may have higher margins if they feel there is excess risk in the market.

Let's say that our analysis on the market is right and the price rises $20.00 per ounce X 100 Troy ounces = $2,000 profit (excluding commissions). Now, you are probably saying, "Well, if I bought the cash Gold, I would still have made the same profit," and you would be absolutely correct. When we break down our return on investment (ROI), we see a big difference in percentage return.

This is the power of leverage! When you post your initial margin of 9 percent, the balance is sort of "loaned" to you interest-free from your broker. You end up controlling an $81,000 contract for a 9 percent escrow, if you will.

Now, remember that "double-edged" sword we mentioned? Leverage can and does cut both ways. This trade just as easily could have been a loss, causing our $20 decline in price to result in losing that same $2,000. With good risk management and the use of a stop for protection, you will at least be able to keep your losses at a minimum. This will allow you to return and play the game again another day.

This leverage can also lead to something known as a "margin call". If and when the funds remaining available in your margin account are reduced by losses to below a certain level – known as "maintenance margin", your broker will require that you deposit additional funds to bring the account back to the level of the "initial margin". If you fail to replenish your account, your broker will liquidate the position at the available market price. You will be held liable for this loss.

In our Gold example discussed previously, you initially deposited $7,425 of initial margin. Currently (for purposes of that same example), the maintenance margin on Gold is $5,500. If during the time, you held your Gold position, and you had a loss of $1,925, you would receive one of these margin calls. This margin money is no more than "good faith" money deposited in your account to assure the brokerage that you will stand behind your losses.

It is essential for anyone considering trading the futures markets – whether it's Bonds, Live Cattle, Corn – to have a good understanding of the concept of leverage. In trading, "Expect nothing; be prepared for anything."

*Reprinted (and modified) with permission from Online Trading Academy (www.onlinetradingacademy.com).

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