Learn About Futures Margin
Margin is a critical concept for people trading commodity futures and derivatives in all asset classes. Futures margin is a good-faith deposit or an amount of capital one needs to post or deposit 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.
Futures exchanges determine and set futures margin rates. At times, brokerage companies will add an extra premium to the minimum exchange margin rate to lower their risk exposure. The margin is set based on the risk of market volatility. When market volatility or price variance moves higher in a futures market, the margin rates rise. When trading stocks, there is a simpler margin arrangement than in the futures market. The equity market allows participants to trade using up to 50% margin. Therefore, one can buy or sell up to $100,000 worth of stock for $50,000.
Margin Rate for Futures Contracts
In the world of futures contracts, the margin rate is much lower. In a typical futures contract, the margin rate varies between 3% and 12% of the total contract value. For example, the buyer of a contract of wheat futures might only have to post $1,700 in margin.
Assuming a total contract of $32,500 ($6.50 x 5,000 bushels) the futures margin would amount to around 5% of the contract value. Initial Futures Margin is the amount of money that is required to open a buy or sell position on a futures contract. Initial margin is original margin, the amount posted when the original trade takes place.
Margin Maintenance is the amount of money necessary when a loss on a futures position requires you to allocate more funds 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, an additional $350 in margin must be posted 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 an additional $3,500 to return the account to the initial margin level. Closing or liquidating a position eliminates the margin call requirement.
Calculating Futures Margin
Exchanges calculate futures margin rates using a program called SPAN. This program measures many variables to arrive at a final number for initial and maintenance margin in each futures market. The most critical variable is the volatility in each futures market. The exchanges adjust their margin requirements based on market conditions.
Margin in Futures Has Many Benefits
Margin is a good faith deposit that a market participant posts with the exchange clearinghouse. Think of margin as 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.
Two of the benefits of margin for market participants are; it guarantees anonymity (the exchange is always your counterparty), and it eliminates counterparty credit risk from the transaction. Exchanges are regulated by the Commodities Futures Trading Commission (CFTC) and have plenty of funds on hand to meet all obligations. Those funds come from the margin collected by market participants.
Since margin is only a small percentage of the total futures contract value, there is a tremendous amount of leverage in futures markets. Look at an example:
- Buy one contract of a COMEX gold future at 1270
- Each contract is for 100 ounces of gold
- Initial margin = $4400
- Sell one contract of COMEX gold future at 1275
- Profit: $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)
- However, since you bought the gold futures contract, the gain is calculated on the amount of margin posted for the trade or $4,400 and the profit would equate to an 11.36% gain ($500/$4,400)
- While the percentage gain in the futures market is high, remember that where there is the potential for rewards, there is always a risk. If you lost $5 per ounce on a one contract gold futures position, your loss would equate to 11.36% as well.
Exchanges set margin levels and constantly review them when market volatility changes; margins can go up or down at any time. Futures Commission Merchants (FCMs) are permitted to require higher margins than exchange levels based on the risk of the customer and their ability to contact them on a moment’s notice.
Margin is the glue that holds the futures markets together in that it allows market participates to trade with confidence that others will meet all obligations at all times.