Market side: Futures trading basics

LESSON 13: MARGIN EXPLAINED

Marty Hibbs, Grain Merchandiser, Grain Farmers of Ontario

This monthly educational series will feature the basic workings of the futures and options markets and how they can be utilized to help farmers with risk management.

WHEN AN INVESTOR opens an account with a brokerage firm, there is a minimum account deposit made.  This amount varies from brokerage to brokerage house. These funds will eventually act as a pool or good will deposit for transactions in that account. For this example, we will open an account with a $5,000 deposit.

Margin is defined as a performance bond or good will security.  In the case of futures trading, the margin required for each contract entered into represents a fraction of the value of the futures contract (usually three to 12 per cent). Using corn as an example, the value of a 5,000 bushel contract of corn trading in Chicago at $4 per bushel is $20,000 (5,000 x $4).

The margin requirement for a trader to enter into one contract of corn is about $1,500 per contract which represents 7.5% of the contract value. This margin deposit is used to secure day to day price fluctuations on any losses and is referred to as marked to market, meaning that any losses or profits from a given day will be added to or subtracted from the clients account available balance at the end of each day. When you liquidate your corn position, you will receive the initial deposit ($1,500) plus or minus profits or losses on that trade.

Initial margin is the minimum amount required to enter into a new futures contract ($1,500), but the maintenance margin is the lowest amount an account can reach before needing to be replenished.

In this case, any losses that would reduce the initial margin of $1,500 to $800 would trigger a margin call to replenish the margin funds back to the initial margin of $1,500. However, since our account was opened with $5,000 then the excess margin would come from the $3,500 available in your account. ($5,000 — initial margin of $1,500 = $3,500). Replenishing the initial margin back to $1,500 would require subtracting $700 from your excess funds of $3,500.

TRADE EXAMPLE
Let’s say that you purchased a December corn contract with an initial margin of $1,500. That $1,500 would be segregated from your account funds ($5,000) leaving $3,500 excess in your trading account. As the days pass, the price of corn drops 12 cents per bushel or $600. This leaves your initial margin balance at $900.

The following day the corn drops another three cents per bushel or $150. This closing price leaves the balance in your initial margin account at $750. Since the maintenance margin is $800, you now receive a margin call of $750 which will replenish your margin to the original $1,500. In this example, this margin would be taken from your available balance of $3,500 in your trading account. Your excess margin would now be calculated as follows:

Original deposit     $5,000

Initial margin         -$1,500
Account balance    $3,500
Margin call               -$800
Account balance    $2,700     •

Marty Hibbs is a 25 year veteran futures trader, analyst, and portfolio manager. Hibbs was a regular guest analyst on BNN for four years. He is currently a grain  merchandiser with Grain Farmers of Ontario.

Lesson Definitions:

Margin: Cash or equivalent posted as a guarantee of fulfillment of a futures contract (not a down payment).

Margin call: Demand for additional funds or equivalent because of adverse price movements or some other contingency.

Marked to market: The practice of crediting or debiting a trader’s account based on the daily closing price of the futures contract.

DISCLAIMER: This information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by the author, by Grain Farmers of Ontario, or by any other person as to its accuracy, completeness or correctness and Grain Farmers of Ontario accepts no liability whatsoever for any loss arising from any use of same.

About Marty Hibbs 29 Articles
Grain Merchandiser, Grain Farmers of Ontario