What Is Futures Margin?
Futures margin is the amount of money a futures trader need to deposit and maintain in his futures trading account in order to open a futures position. This deposit, known as the Initial Margin, is required whether you are long or short a futures position and is usually 20% of the value of assets covered in the futures contract in the case of a Single Stock Futures trade.
As futures contracts are settled at the end of each day (known as marking to market), profits are added and losses are deducted from this initial margin amount. When the initial margin amount is reduced to a certain level (known as the Maintenance Margin) due to losses, the broker will ask the trader to top up the margin (known as Variation Margin) back up to the initial margin amount in what is known as a margin call.
Relationship Between Initial Margin, Maintenance Margin, Margin Call and Variation Margin
Now that you had an overview of what margin is in futures trading, lets take a closer look at the different aspects of futures margin mentioned above; Initial Margin, Maintenance Margin, Variation Margin and Margin Call.
Initial margin is the cash deposit required to be put forward when opening a new futures position which is determined based on a percentage of the full contract value. Opening a futures position means to go long or go short on futures contracts. Initial margin applies in futures trading no matter if you are long or short a futures position. This is unlike in options trading where you actually receive money instead of pay money when putting on a short options position.
Initial margin is calculated based on a percentage of the total value covered under the futures contracts. This percentage varies according to the futures market that you are trading. In single stock futures trading, the required initial margin is 20% of the value of the contract in the USA. Initial margin for more index futures and commodities futures around the world are calculated using a system known as "SPAN Margin" which may vary from day to day.
Initial Margin Example:
Assuming you go long on the futures contracts for XYZ stock trading at $10 covering 100 shares.
Total value covered under futures contract = $10 x 100 = $1000
Initial margin required = $1000 x 20% = $200
Initial margin is a deposit made. This means that it remains your money unless deducted due to losses. As all futures contracts are marked to market daily, which means that they settle their wins and losses on a daily basis in order to control risk, wins are added onto your initial margin deposit while losses are deducted from your initial margin deposit.
Initial Margin Example:
Following up from the above example. Assuming at the end of the first trading day, XYZ stock rises to $10.10.
Total Profit = ($10.10 - $10) x 1000 = $0.10 x 1000 = $100
Margin balance = $200 + $100 = $300
As you can see in the example above, XYZ rises $0.10 on the first day of trade and the very same day, those profits on that 1000 shares are added directly onto your margin balance. Here you can see the leverage effect of futures trading as well, making a big 50% profit on your invested capital of $200 on a mere $0.10 gain on the stock. However, leverage cuts both ways. Lets see what happens when the stock falls.
Initial Margin Example:
Following up from the above example. Assuming at the end of the second trading day, XYZ stock drops to $9.90.
Total loss = ($10.10 - $9.90) x 1000 = $0.20 x 1000 = $200
Margin Balance = $300 - $200 = $100
As you can see above, losses for the day are once again taken off from your margin balance. What happens when your margin balance goes that low? This is when you need to check the maintenance margin requirement for the position.
Read the full tutorial on Initial Margin
So, how low can your margin balance go before your broker becomes uncomfortable? When its lower than the Maintenance Margin required of the position.
Maintenance Margin is the minimum amount of margin balance that you need to have in your account in order to keep your futures position valid. Maintenance margin is the minimum amount of money which your broker or the exchange require you to have in your account so that losses can be deducted from it. Anything lower than that increases the risk that you may not have enough money to be deductible against losses.
Maintenance margin for trading Single Stock Futures in the US market is 20% of the cash value of the futures contract. Yes, it is the same level as the initial margin. Maintenance margin requirement would vary according to the specific market you are trading in.
Once your margin balance falls below maintenance margin level, you will receive what is known as a "Margin Call" from your broker.
Read the full tutorial on Maintenance Margin
The most dreaded term in futures trading is definitely "Margin Call". A margin call is a "call" from your broker requiring you to top up cash into your account when your margin balance for your futures position drops below the maintenance margin level.
The additional amount of cash that is needed to bring your margin balance back up to the initial margin level from the maintenance margin level is known as the "Variation Margin". This means that you will receive a margin call to deposit variation margin into your account to bring it back up to the initial margin level when the margin balance drops below maintenance margin.
Initial Margin Example:
Following up from the above example.
Since maintenance margin for single stock futures is the same level as the initial margin, the margin balance of $100 remaining is below the maintenance margin of $200. You receive a margin call from your broker to top up:
Variation Margin = $200 - $100 = $100
Topping up $100 will bring your margin balance back up to $200, which is the initial margin level.
What if you do not have the money to fulfill the Variation Margin requirement? Your futures position will then be forcefully liquidated by your broker and you will no longer own that position. Whatever losses that have accrued would be realised.
Read the full tutorial on Margin Call
Benefits Of Futures Margin
The main benefit of margin in futures trading is that it prevents a buildup of losses. Futures trading is highly leveraged as you can see from the examples above. In order to prevent a buildup of losses that can quickly cause a position to become illiquid, the maintenance margin system is created. The maintenance margin is a general risk hedging mechanism that prevents your position from becoming illiquid. Instead of waiting for your entire equity in the position in the form of your initial margin to be wiped out, the exchange requires you to top it up whenever it reaches a certain level. In Single stock futures trading, this level is the same level as your initial margin. This means that if you take a loss on the very first day of putting on the position, you will receive a margin call to top up your margin back up to the initial margin level.
This system also lowers the risk of non-performance of futures contract obligations. Futures contracts are binding contracts that must be performed and settled. The margin system makes sure that all futures contracts have the equity in them for settlement and provides the liquid and safe futures trading environment that exist today.
Disadvantages of Futures Margin
The single most significant disadvantage of the futures margin system is the fact that losses must be settled on a daily basis and that really tests your holding power. If you have the holding power to maintain your margin balance, you may eventually end up winning as a temporarily losing position turns around in a few days. If you do not have the liquidity to fulfil your margin call, you will lose the position and miss out on the gains should the asset turn around in a few day's time.