Introduction To Futures
The Basics of Futures Trading
Margins
The exchanges and their members are able to guarantee all trades because they require all parties in a transaction to deposit performance bond margins. Performance bond margins are financial guarantees required of both buyers and sellers of futures contracts to ensure fulfillment of the contract obligations. That is, buyers and sellers are required to take or make delivery of the commodity or financial instrument represented by the futures contract unless the position is offset before the contract expiration.
Before entering into a transaction, both parties have to post an Initial Margin Requirement. The initial margin requirement is the amount of money a party must have on account with a clearing firm (your broker) at the time the order is placed. Initial margin funds must be on deposit before any trade can be accepted. Maintenance Margin is a set minimum margin (per outstanding futures contract) that a party to a futures contract must maintain in his/her margin account to hold a futures position. Initial margin requirements vary from commodity to commodity, but are generally between 5% and 10% of the total value of the contract.
Example
If March Corn futures are trading at $2.11/bushel, the initial Margin
Requirement for CBOT Corn futures is $405.00 per contract, with a
maintenance margin requirement of $300.00. Our speculator must have at
least $405.00 on deposit with his broker before he could enter the
market. He would need to have an account liquidating value of at least
$300.00 per contract in order to stay in the position.
Let’s assume that our speculator has $1,000 in his account and decides to buy 2 contracts of March Corn at $2.35/bushel on January 2nd. He is able to buy this because he has more than the initial margin requirement of $810.00 ($405.00 initial margin x 2 contracts = $810.00). With a $50.00 round turn commission rate ($25.00 in and $25.00 out) our speculator’s broker would charge him $50.00 in commissions as well.
If March Corn settled at his entry price of $2.35/bushel, his account liquidating value would be $950.00 ($1,000.00 initial deposit - $50.00 commission) to buy 2 contracts of Corn. Since the liquidating value of the speculators account (funds on deposit + open position profit or loss) is greater than the maintenance margin requirement of $300.00 per contract or $600.00 for 2 March Corn, he is able to stay in the trade.
The next day, much to our speculators detriment, Corn prices drop by 5 cents. Our speculator now has an open position loss of -$500.00 and an account liquidating value of $450.00 ($1,000.00 - $50.00 commission - $500.00 open position loss = $450.00). Since this value is less than the Maintenance Margin requirement of $300.00 per contract, or $600.00, our speculator is on a Margin Call.
In order to keep the position, the speculator must either send enough money to bring the account back above the Initial Margin Requirement of $810.00 or liquidate the position. The Maintenance Margin Requirement is the minimum amount of money which must be in the account (including open position profits and losses) to maintain an open position in the futures market. If the value of the account dips below this level, then the account holder must either send additional funds to his broker or liquidate the position. Usually, traders have 5 business days to get funds posted to the account, but in some cases the brokerage firm may liquidate the futures positions in order to meet the Margin Call.
Reminder
Brokerages have the right to liquidate your position immediately, and
many may require you to wire funds right away to avoid liquidation. Be
aware that margin requirements are subject to change without notice.
Initial Margin is the minimum amount of money you must have in your account to open up a futures position. Maintenance Margin is the minimum amount of money you must have in your account to maintain the position.
In the Corn example, the initial margin was $405.00 per contract, meaning that a trader must have at least $405.00 per contract in his margin account before a Corn futures position can be entered into. After the position is entered into a balance of $300.00 per contract, the Maintenance Margin must be maintained in order for the position to be left open. If the available funds in the account (funds deposited + open position profit or loss) are less than the Maintenance Margin Requirement, then more funds must be deposited or the futures positions will be liquidated or offset by taking an opposite position in the futures market.
Reminder
Long or buy positions are offset or closed by selling, while short or
sell positions are offset or closed out by buying.
The dual margining system (initial and maintenance) of the futures market ensures that all positions are adequately financed and the integrity of the futures market is secure. The exchanges set the minimum margin requirement based on the volatility and dollar value of the contract. Margin levels are subject to change both up and down at the discretion of the Exchange. Most brokerage firms charge the exchange minimum margin, but they are entitled to charge more. Be sure to check with your broker before entering into any futures transaction.