As is apparent from the preceding discussion, the arithmetic of leverage is the arithmetic of margins. An understanding of the different kinds of margins is essential to an understanding of futures trading.
If your previous investment experience has mainly involved common stocks, you know that the term margin as used in connection with securities has to do with the cash down payment and money borrowed from a broker to purchase stocks. But used in connection with futures trading, margin has an altogether different meaning and serves an altogether different purpose.
Rather than providing a down payment, the margin required to buy or sell a futures contract is a deposit of good faith money that can be drawn on by your brokerage firm to cover any day-to-day losses that you may incur in the course of futures trading. It is much like money held in an escrow account. When you liquidate a futures position, your margin deposit is refunded to you, plus any undistributed profits or minus any uncollected losses on the trade.
Minimum margin requirements for a particular futures contract at a particular time are set by the exchange on which the contract is traded. They are typically five to 10 percent of the value of the futures contract. Exchanges continuously monitor market conditions and risks and, as necessary, raise or reduce their margin requirements. An increase in market volatility and the range of daily price movements is frequently a reason for raising margins.
Note that the exchanges’ minimum margin requirements are exactly that: minimums that exchange-member brokerage firms must charge. Individual firms may have margin requirements higher than the exchange minimums.
There are two margin-related terms you should know: Initial margin and Maintenance margin.
Initial margin (sometimes called original margin) is the sum of money that you must deposit at the outset with the brokerage firm for each futures contract to be bought or sold. On any day that profits accrue to your open positions, the profits will be added to the balance in your margin account. On any day losses accrue, the losses will be deducted from the balance in your brokerage account.
If and when the funds remaining in your account are reduced by losses to below a certain level known as the maintenance margin level—your broker will require that you deposit additional funds to bring the balance back to the level of the initial margin. Or you may be asked for additional margin if the exchange or your brokerage firm raises its margin requirements. Requests for additional margin are known as margin calls.
Assume, for example, that the initial margin needed to buy or sell a particular futures contract is $2,000 and that the maintenance margin is $1,500. Should losses on open positions reduce the funds remaining in your trading account to $1,400 (an amount less than the maintenance requirement), you will receive a margin call for the $600 needed to restore your account to $2,000.
Before trading in futures contracts, be sure you understand your particular brokerage firm’s Margin Agreement and how and when the firm expects margin calls to be met. Some firms may require only that you mail a personal check. Others may insist you wire transfer funds from your bank or provide same-day or next-day delivery of a certified or cashier’s check. If margin calls are not met in the prescribed time and form, the brokerage firm can protect itself by liquidating your open positions at the available market price (possibly resulting in an unsecured loss for which you would be liable).
Reprinted with permission from the National Futures Association. Copyright 2002.