The concept of margin is sometimes confusing for new futures traders because it is very different than the margin used for buying stocks, exchange-traded funds, or bonds. In the world of stock trading, margin is a down payment, often up to 50% of the value of the purchase, to take ownership of the shares. In futures trading, on the other hand, margin is a good faith deposit and not a down payment. Let's see how it works.
The Power of Leverage
Futures margin is a sum of money deposited and held in the brokerage account when a futures position is opened. The dollar amount is set by the futures exchanges and typically varies between 5 and 10% of the value of the contract. For instance, if the value of the futures contract is $100,000 and the margin is 7.5%, the deposit or initial margin is $7,500 per contract.
Example: A bushel of corn trades $6.50 and one contract represents 5,000 bushels. Therefore, the value of the contract is: $6.5 x 5,000 = $32,500. If the initial margin is set a 5%, how much must be deposited to buy one contract: 32,500 x .05 = $1,625. If prices rally and a bushel of corn is now worth $6.75, how much is gain or lost: one contract is now worth $6.75 or $33,750 for 5,000 bushels and the account holder has $1,250 in profits, or $33,750 – 32,500. There’s the power of leverage!
The margin amounts vary based on the volatility of the underlying security. For example, trading longer-term Treasury bonds requires a lot less margin compared to opening positions on the S&P 500 Index. Also note that, while the levels are determined by the exchanges, your broker will sometimes add to the exchange-set margin requirements to reduce risk exposure.
To see how margin works in real-world situations, keep in mind, that there are two types of margin when dealing with futures:
- Initial Margin Requirement: The amount deposited when opening a new (buy or sell) position in a futures contract. Then, multiply the margin requirement by the number of contracts traded to compute the total initial or original margin.
- Maintenance Margin Requirement: The amount of money needed to cover a loss on a futures position in order to return the margin to the initial or original margin level. If the position value drops below the maintenance level, the account holder will receive a margin call.
Example: If you take a position requiring $8,000 initial margin and $6,500 maintenance margin, a margin call will be triggered if the value drops to $6,500 or less. At that point, you're required to restore it to the initial margin amount of $8,000. So, if it drops to $6,000, a $2,000 deposit is required or, unless you can reduce the size of the position to meet the margin call, the position will be liquidated once it drops below the maintenance margin level.
Know Position Size
Day traders typically don’t worry about maintenance margin or margin calls because their positions are covered or closed out by the end of the trading day. Seeing a position value drop substantially below margin levels is rarely an issue during an intraday trade. On the other hand, consistent margin calls from your broker is probably a sign that your trading system is flawed and there’s a need for greater risk management.