A very common misunderstanding for investors new to futures trading is the term “margins” and what it exactly means. Let’s begin with the definition of margin as it applies to the stock or equities markets. ‘Margin’ is a term used to describe when money is borrowed to purchase a stock or security. Basically, ‘Margin’ is a loan typically provided by a stock broker to it’s client to enable he/she to purchase additional shares of stock with the loan of additional funds.
The term ‘Margin’ is also present in the commodity futures and options market as well but has a completely different meaning as compared to the stock markets meaning.
When trading commodity futures, the term ‘Margin” is the amount of funds an investor must have available in his/her account to open a position in a particular market. ‘Margin’ in commodity futures trading can be thought of as a “Performance Bond”. Available “Margin” funds in a clients account act as a deposit of “good faith” in return for establishing a position in a given market. As an example, if an investor wished to establish a position in the Corn market, he/she would need to have $1.485* in available funds in his account to take a long or short position for one contract. Again, this ‘Margin’ amount is not deducted from the futures trading account, it is now acting as a deposit enabling the futures trader to take a position in the Corn market.
Margin is determined by the futures exchange in which you wish to trade on. The original amount of money the exchange requires you to deposit is called Initial Margin. Initial Margin can also be thought of as “Day One” margin as it is the amount of margin required when the futures position is originally established. This amount is typically anywhere between 5-10% of the contract’s overall value, and is periodically subject to change based upon current market conditions.
Along with the initial margin required by the futures exchange, there is also Maintenance Margin for your account. Maintenance Margin is a lower dollar amount than Initial Margin and comes into play starting with the second day of an established futures position. Essentially, the futures exchange will require a higher deposit to establish a futures position through Initial Margin. Once a futures position has been establish, the exchange then lowers the deposit amount (approximately 20%) down to Maintenance Margin to give the trade “room to fluctuate”.
If the market moves against your established position and your account equity falls below the maintenance margin, you will receive a Margin Call. A margin call is a request from your broker to either deposit funds into your account to bring the account value back up to the original initial margin amount or liquidate the open futures position. Most futures brokers require margin calls be taken care of immediately. If a margin call is not satisfied, the futures broker has the right to liquidate any open positions in order to satisfy the margin deficit.
The majority of futures traders will not want to take delivery of the contract they are trading, so they will liquidate the contract before its expiration date. When a contract in which you own the rights is liquidated, your margin deposit is then cleared. Depending on the outcome of the trade, losses are subtracted or gains are added to your futures trading account.
* Based upon current exchange margin rates as of December 16. 2009. Margins are subject to change without notice.
THERE IS A SUBSTANTIAL RISK OF LOSS INVOLVED IN FUTURES TRADING AND IS NOT SUITABLE FOR ALL INVESTORS.