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How Do Margins Work?
Perhaps the biggest advantage to trading futures contracts is the leverage provided by the
exchange. However, controlling large contracts with relatively low amounts of capital can create
high levels of volatility. As a result, many traders will argue that leverage is actually a
disadvantage. Regardless of your opinion on leverage and margin requirements, it is important
that you fully understand the concepts.
Before a customer can establish a position he is required to make a minimum “good faith
deposit,” or margin, to assure the performance of his obligations. A margin deposit is, in
essence, a performance bond, which is usually between 5% and 10% of the underlying
contract value. A good faith deposit indicates the buyer or seller’s willingness and capability to
compensate the opposite party to a transaction.
Because margin requirements are low, hedgers are given the ability to lock in pricing of cash
market goods without tying up a lot of capital. It would be counter productive for a hedger who
handles large quantities to put up 100% of the value of the hedged commodity. The exchange
grants margin discounts to those that are deemed to be “bonefied” hedgers, due to the fact that
the underlying cash position is seen as collateral to secure the capital risked in the futures
market.
Low margins make speculation in the futures markets very attractive, without the advantage of
leverage the rate of return on most commodities would be marginal. The exchanges are
responsible for setting margin requirements, but brokerage firms have discretion to require
higher deposits. Generally, the initial margin is sufficient to cover the maximum daily price
fluctuations. It is not uncommon for margin requirements to fluctuate with the volatility of the
market. A maintenance level is established below the initial margin, usually 75% of the initial
margin. Once a trader's good faith deposit falls below this threshold additional funds must be
deposited or positions must be liquidated. This is known as a margin call.
Orders
There are several types of orders that can be placed. In order to maximize efficiency and
profitability, traders must be comfortable in executing each of the following options.
Market Order: The purpose of a market order is to execute a trade immediately at the best
possible price. Such orders give traders the ability to enter or exit a trade quickly, but do not
guarantee a favorable price. This order should be used when time is more valuable than price.
Limit Order: Limit orders are used to buy or sell at a specified price or better, and will only be
filled at the state price or one that is more favorable. For a sell limit order “better” means
higher, for buy limit orders “better” means lower.
Stop Order: This type of order is usually placed to close a position; its name is derived from the
fact that, if placed properly, it will “stop loss” should the market go against a trader’s position.
Most traders chose to place a stop order at the time that they enter a position. By definition, a
sell stop will be placed below the market while a buy stop will be placed above.
All orders are day orders unless specified otherwise and are canceled at the end of the trading
day. By entering the order GTC (good ‘til canceled), the order will be working in each trading
session until canceled by the trader.
Execution
Many beginning traders are unaware of the mechanics of executing a futures trade. When you
call your broker, an order ticket is completed and time stamped in order to keep accurate track
of the time and specifics of each order. The broker then transmits the order to his firm’s trading
desk located on the floor of the exchange either by a computerized trading platform or by
phone. The order clerk then fills out an order card, time stamps it, and hands it to a runner who
will take it directly to a broker in the pit. The pit broker will execute the order by open outcry and
record the execution on the card before it is given back to the runner. The runner takes the
executed order back to the desk where the order clerk time stamps the card one more time
before the fill is reported to your broker.
Before a customer
can establish a
position they are
required to make a
minimum “good faith
deposit,” or
“margin,” to assure
the performance of
their obligations.
Futures Traders Helping Future Traders
