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Notational Funds & Leverage

Here is an interesting fact: the face value of over-the-counter derivatives is approximately $500 trillion; this amount stands in stark contrast when compared against the combined GDPs of all nations in the world, estimated to be $50 trillion. Question is, how is it possible that these derivatives are worth ten times more than all the economies of the world? The answer is that this $500 trillion amount refers to the nominal value, which is the stated value of the derivative. Simply, this amount does not represent real money, but references an amount used to construct the contract.

Futures contracts are also constructed around the concept of a nominal face value. This amount fluctuates based on the contract's trading unit size and quoted price. For example, wheat futures are quoted as 1/4 cent per bushel, and a single wheat contract involves the delivery of 5,000 bushels as a result, assuming the contract settles at $8.96, the contract's mark-to-market value is $44,800. This is the amount which a buyer would need to pay if he/she were to take delivery of 5,000 bushels of wheat. It is important to note, however, that commodity futures traders seldom make or take delivery of the underlying cash asset, but instead liquidate the futures contract before the delivery period. Accordingly, a futures trader does not need to come up with the $44,800 cash, but instead, is only required to put up an initial margin requirement. Margin requirements for futures are akin to a good faith deposit. This is very different from how margin is defined for the purpose of trading securities. When trading securities, an investor "borrows" money from the broker which is collateralized by other assets held in the account. The limit on borrowing in this manner is currently set at 50% of marginable securities. This limit has not been changed in many years.

On the other hand, the good faith deposit required to trade a futures contract can be as low as just 2% of the contract's nominal face value. As of this writing, the initial margin requirement for a wheat futures contract is $6,075 and the maintenance margin requirement is set at $4,500. This is all that the investor has to maintain in his/her account to trade a wheat futures contract. However, if the mark-to-market value of the account drops below the maintenance requirement, additional monies must be deposited in order to maintain the position. Otherwise, the position must be liquidated. This relationship between margin requirement and the nominal face value of a futures contract constitutes leverage. Leverage allows commodity trading advisors the potential to produce high returns as well as large losses. An important factor to know then is the average and maximum amount of margin a trading program requires to be traded.

Margin-to-Equity Concept

The above description serves as necessary background in order to begin discussing managed futures and notional funding. This is where the proverbial rubber hits the road. When a commodity trading advisor designs a trading program, he or she usually establishes a baseline account level which determines the number of contracts that he/she will trade for that unit size. The aggregate margin requirement for these contracts is then divided into the account level in order to determine the margin-to-equity ratio.

Guide:

  1. About Managed Futures
  2. Benefits of Managed Futures
  3. Selecting a Managed Futures Program
  4. Notational Funds & Leverage