Margin trading
About margin trading
Generally, in the equity markets, a margin refers to borrowed money in order to purchase securities. In the futures and Forex market, a margin is money a trader must deposit in the form of either cash or marginable securities with a broker, on a per contract basis, before opening a position. In this agreement, the trader composes a cash down payment (margin) with the broker and is able to buy stocks worth higher than what was actually deposited.
Additionally, the broker charges interest on the loan and the trader has to hold the stocks with the broker as a guarantee. In case the value of the stock drops under a certain amount, the trader will need to deposit additional money in order to hold that position. The reason why trading on margin is tempting for traders, is that it actually allows them to open trades bigger than the capital that they own in their account.
Traders however, must be cautious when trading on margin as it is a double-edged sword. If a stock goes up, the trader can make twice as much profit but in the same way, if the stock goes down, the trader will eventually lose twice as much. It is important to always have this characteristic in mind when trading.
What are future margin?
The initial margin is the amount of money that needs to be deposited when opening a new futures position. Initial margin relates to future trading and does not differ if the trader goes long or short a futures position. Moreover, the calculation of the initial margin is based on a percentage of the total value covered by the futures contracts.
The percentage of total value covered differs based on the futures market that the investor is trading in. In terms of stock futures the initial margin needed is 20% of the value of the contract and for index futures and commodities futures, a calculation system is required. This calculation system is called ‘SPAN Margin’.
Futures are simply an exchange-traded forward contract. Futures margin is the sum of money futures a trader needs to invest and hold in his account to open a futures position. This investment is called the Initial Margin and it is compulsory no matter if the futures position is long or short.
In addition, futures contracts are completed at the end of each day and the difference from the initial margin is either added or deducted in the trader’s account. If the initial margin moves to a lower level (Maintenance Margin) due to losses, the broker will need to top-up the margin (Variation Margin) in their account to the initial margin level and this is called a Margin Call.
Initial margin
Maintenance margin
The maintenance margin is the minimum sum of margin balance that traders need to have in their account in order to keep their futures position valid. In addition, the maintenance margin requirements would differ depending to the specific market that the trader trades in. when the margin level drops under the maintenance margin level the trader will receive a ‘Margin Call’ from the broker.
Margin call
A margin call is an alert from the trader’s broker, notifying that there is a need to deposit money in his/her account when their margin level for the futures position dropped under the maintenance margin level. The additional sum of money needed to bring the margin level back to the initial margin is called ‘Variation Margin’.
The variation margin indicates that the trader will receive a Margin Call from the broker to deposit the necessary margin in the account in order to bring the margin level back to the initial margin.
Example
For example, let’s suppose a trader buys a futures contract for ‘X’ stock trading at $30 for 200 shares.
- Total value covered: $30 x 200 = $6.000
- Initial margin required: $6.000 x 20% = $1.200
Now, let’s assume that the first trading day has come to an end and the price of the ‘X’ stock rises to $30.10.
- Total Profit: ($30.10-$30) x $6.000= $0.10 x 6.000= $600
- Margin Balance: $1.200 + $600= $1.800
As can be observed above, the leverage effect of futures trading made a profit on the invested capital, just by a small $0.10 gain on the stock. Conversely, leverage cuts also if the stock drops. Suppose that the end of the second trading day the price of the ‘X’ stock drops to $29.90.
- Total loss: ($30.10 – $29.90) x $6.000= $0.20 x 6.000 = $1.200
- Margin Balance: $1.800 – $1.200 = $600
Here, the losses generated are taken out of the traders margin balance.
Benefits
High leverage
Futures contracts are highly leveraged financial instruments. Traders have the possibility to enter the market with a fairly small investment (margin) and end up with large profits. As always though, the coin has two sides. A trader can either generate large profits but if the predictions turn out to be wrong, then he will end up with large losses. However, the reason that futures trading are tempting for traders is that it provides the opportunity to receive excellent return.
Low commission charges
The commission charges by brokers for futures trading are fairly low and only when the trader closes his/her position the commission is paid. The commission charges differ depending on the services offered by the broker, which range from as low as $5 up to $200.
Disadvantages
The greatest disadvantage when trading of futures margin is that losses must be completed on a daily basis. If at the end of each day the trader manages to hold his position open without running out of margin, then he will generate profit. On the other hand though, if the margin runs low, the position will be lost and the trader will be asked to top-up the margin in his account.
