Margin Requirements in Futures Trading
The term ‘margin' is used very frequently in futures trading. It refers to the amount the holder of the financial instruments deposits with the counterparty, usually an exchange or a broker, to cover the credit risk. The risk normally arises when the holder either entered into a derivative contract or borrowed money to purchase financial instruments from the above mentioned counterparty or sold financial instruments short.
Margin amount serves as collateral in futures trading and usually is in the form of cash or securities and deposited in a ‘margin account'. The percentage of margin rate is fixed by the futures exchanges and in some cases, brokerage firms add up further premium over and above the minimum rate to reduce their risk exposure. Ex: A contract of sugar futures is worth $20,000 and usually the margin rate range from 5-15%. Hence, to buy the above contract, you are required to have a margin of minimum $1,000 (20,000 * 5%).
Types of margin requirements:
• Initial Futures Margin – The obligatory minimum amount to open a buy or sell position on a futures contract.
• Maintenance Margin – The amount required to keep an open position and entails adjustment to the initial margin in the form of daily payment of profits and losses. The prevailing price of futures is compared to the previous day's price, usually known as ‘marked-to-market'.
Profit is earned for the day, if the current price is higher and the profit amount is paid to your margin account, thereby resulting in increment in your margin amount. However, loss is incurred if the price falls below the previous day's closing; the loss amount is debited to your margin account, resulting in fall in margin amount.
• Additional Margin – Such margin is meant to cover any expected drop in the value of your position on the next trading day.
• Margin Call – A Margin call is issued by your broker or the exchange, in the event of amount in your margin account drops below the maintenance margin. In such a case, you can either raise your amount to the initial margin level or close your position.
To ensure smooth flow of your futures trading, keep track of the margin requirements.
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