Premiums vs. margin vs. leverage

Purchasing a derivative doesn’t work entirely the same that a stock does. Since these are contracts based on future transactions, the investor doesn’t have to produce up-front capital in the same way he would for a stock exchange.

He can’t, after all; the transaction hasn’t happened yet.

However, at the same time, the system needs some sort of initial capitalization both to incentivize sellers and to reduce careless transactions. Three main vehicles take the place of a purchase price when trading derivatives: premiums, margins, and leverage. Here’s each, and how they work.

Premiums

These are the simplest.

A premium is the up-front price required to sign an options contract. This is a flat fee set by the seller of the option, generally valued at whatever the seller considers the risk of this trade. (http://www.nasdaq.com/investing/options-guide/pricing-options.aspx) (https://blog.bestchoicesoftware.com/2016/11/21/e-z-guide-to-stock-option-basics/)

A premium acts as the profit motive to sell an option. Since the buyer of an option can walk away at any time, the vehicle has no inherent value to the other side. It’s the ultimate heads-I-win, tails-you-lose transaction: there’s no market profit for the seller of an option.

Instead the option seller profits off of his premium. As a fixed fee the seller keeps this premium whether the buyer exercises the contract or not.

Margins

In the futures market, the most difficult problem is ensuring downstream payment. Unlike options, where premiums secure the seller’s profit, a futures contract requires not just that both parties exercise at the appropriate date and time but that both parties be sufficiently solvent.

Where should you pull margin money from? (https://blog.bestchoicesoftware.com/2016/12/23/risk-capital-and-its-role-in-your-portfolio/)

A contract to buy coffee beans next July does no good if, come the summer, the buyer can’t afford it.

This is where margins come in.

A margin account is the initial amount of money a trader must put in to start trading. It’s an account held by the trader and the amount is set by the value of the futures contract. She doesn’t have to put in the full value of her trades, simply enough to establish a base level of liquidity.

Maintenance margins may also be required.

Over time the value of a trader’s account will fluctuate as prices rise and fall before the contract closes. The trader may, therefore, be required to invest additional money into her margin account in order to maintain it at a certain percentage of the total value of her contracts.

Leverage

Finally, leverage.

Leverage is the amount by which your contract exceeds your liquid assets.

One of the key elements of the derivatives marketplace, both futures and options, is that an investor can control a lot of assets with a relatively small amount of money. The value of an options or futures contract vastly exceeds the costs associated with opening it, allowing a trader to enter into one with very little money down.

For contracts that pay off, this can be an outstanding way to turn meager capital into huge profits. However, for contracts that fail to deliver, particularly with futures, it can be a road to ruin.

Want to know more about how to make, and lose, money with derivatives? (https://blog.bestchoicesoftware.com/2016/12/28/three-great-ways-to-make-and-lose-money-with-derivatives/)

Leverage describes entering contracts whose value exceeds the assets in the trader’s account. The amount that a trader is leveraged is generally considered to be the amount by which his contract value exceeds his assets.

Although risky, this is a powerful tool. By allowing a trader to control large amounts of assets with relatively little capital, leverage enables that trader to reinvest his other capital elsewhere.

Of course, if things go wrong and the money isn’t there to pay … well, that’s why “highly leveraged” is not considered a good thing.