Whether you're a broker by trade, or new to the market and looking for ways to make big gains, chances are you've heard a lot about margin. Margin is a crucial concept for those dealing in commodity futures and derivatives of all classes. Futures margin is a good-faith deposit or an amount of money one needs to post into their account to control a futures contract. Margins in the futures markets are not down payments like stock margins. Instead, they are performance bonds designed to ensure that traders can meet their financial obligations.
Future margin and trading on margin have distinct meanings. Simply put, trading on margin is a way to invest on credit, by taking out a loan from your current brokerage fund to buy stocks or other securities. Future margin is a figure: the amount money you are required to keep in your account to enter into a futures position, as a percent of the full value of the futures contract.
Futures margin rates are set by futures exchanges, not by brokers. At times though, brokerage firms will add an extra fee to the margin rate set by the exchange, in order to lower their risk exposure. The margin is set based on how stable the market is (or isn't), and the risk of changes in pricing. When market volatility or price variance moves higher in a futures market, the margin rates rise. When trading stocks, the margin is much more simple: the equity market allows people to trade using up to 50% margin. You can buy or sell up to $100,000 worth of stock for $50,000.
Key Figures in Margin Futures Contracts
In the world of futures contracts, the margin rate is much lower. In a standard futures contract, the margin rate varies between 3% and 12% of the total value of the contract.
The initial futures margin is the amount of money that you need to open a buy or sell on position on a futures contract. Initial margin is also called original margin, or the same amount posted when the trade first takes place.
For example, assume an initial margin of 5%: the buyer of a contract of wheat futures that is valued at $32,500 ($6.50 x 5,000 bushels) may only have to post $1,700 in margin, 5% of the contract value. (They may need to post more to cover any brokerage fees.)
The maintenance margin is the amount of money you need to keep in your fund at any given time to cover your losses; if a futures position suffers a loss, you will need to put enough money in your account to return the margin to the initial or original margin level.
For example, say the margin on a corn futures contract is $1,000 and the maintenance margin is $700. The purchase of a corn futures contract requires $1,000 in initial margin. If the price of corn drops 7 cents, or $350, yo must post an extra $350 in margin to bring the level back to the initial level.
Margin calls are triggered when the value of an account drops below the maintenance level. For example, say you hold five futures contracts that have an initial margin of $10,000 and a maintenance margin of $7,000. When the value of your account falls to $6,500 a margin call will require you to put $3,500 more in your account to return the account to the initial margin level. The margin call is eliminated if yo close or sell your futures contract.
Calculating Futures Margin
Exchanges calculate futures margin rates using a program called SPAN. This program measures many figures to arrive at a final number for initial and maintenance margin in each futures market. The biggest factor in setting margins is the volatility in each futures market, or how stable (or unstable) it might be in the future. The exchanges adjust their margin settings based on market conditions.
Margin in Futures Has Many Benefits
Margin is a good faith deposit that a buyer posts with the exchange clearinghouse. One way to think about margin is somewhat like a down payment on the full value of the contract that you are trading. Margin allows the exchange to become the buyer for every seller and the seller for every buyer of a futures contract, or in technical terms, a counterparty.
There are a few ways that market participants can benefit from margin. For the buyer it guarantees anonymity, since it's made in the name of the exchange. For the exchange, it eliminates credit risk from the transaction, through a method to assure that funds are in place to cover loss.
Exchanges are regulated by the Commodities Futures Trading Commission (CFTC). They are able to meet their contracts through funds from the margin collected by people who invest or sell in the market.
Since margin is only a small portion of the total futures contract value, there is a great deal of leverage in futures markets. Look at an example:
- You buy one contract of a COMEX gold future at 1270
- Each contract is for 100 ounces of gold
- The initial margin is $4400
- You sell one contract of COMEX gold future at 1275
- You make a profit of $5 per ounce, or $500 per contract
- If you bought the actual gold and made a $5 profit that would equate to a 0.3937% gain ($5/$1,270)
- Since you bought the gold futures contract, the gain comes from the amount of margin posted for the trade or $4,400; your profit would equal an 11.36% gain ($500/$4,400)
While the gain in the futures market is high, there is always a risk. If instead of making a profit you lost $5 per ounce on a one contract gold futures position, your loss would equate to 11.36% as well.
Margins are set and reviewed often, and since market volatility changes, margins can go up or down at any time. Futures Commission Merchants (FCMs) are allowed to set higher margins than exchange levels based on the risk of the buyer and also on whether they can contact them on a moment’s notice.
In spite of its risk to buyers, some think of margin as the glue that holds the futures markets together; it allows buyers and those in the market on each side of a deal to trade with confidence, knowing that the others will meet their obligations at all times.