Margin: The Power of Leverage
Futures contracts are highly leveraged instruments. This is what makes them an appealing investment, and also a risky one. Leverage means that the traders need only commit a little money to control a lot of product. Since a futures contract is based on deferred delivery, no money is exchanged at the time a trader buy or sell the futures contract. Therefore, not a lot of money is needed to buy or sell a futures contract. The margin that traders have to deposit when they buy or sell a futures contract, represents a performance bond - a guarantee that they can handle the risk of the futures position.
A futures margin deposit is not the same as margin on stock purchases. Both margins secure one's purchases or sales, but they differ in many ways. Stock market margins are a form of down payment for the purchases of an asset. A futures margin is more of a performance pledge, ensuring that obligations will be honored. Since a futures deposit is not an extension of credit (like a stock margin is), one may earn interest rather than pay it. Moreover, while a stock margin is typically 50% of the value of the purchased assets, a futures margin generally ranges from 5-10% of the contract value.
There are two kinds of margin: initial margin and maintenance margin. Initial margin is that minimum amount of cash that must reside in the trader's trading account the first day that he establishes a futures position, whether long or short, and ranges from 2% to 20% of the market value of the futures position, although it can be less. Maintenance margin is that minimum amount of cash that must reside in the trading account the second day and every subsequent day so long as the trader continues to carry the futures position. Maintenance margin is usually less than initial margin, so the amount of cash one needs to carry a position is less than that required to establish the position. Margin requirements are met by the cash or equity in the trader's account and that equity is eroded if his futures position starts to lose money. (Equity increases if his position becomes profitable.) If total equity in his account falls below the maintenance margin level, then he will be required to close open positions or to deposit additional funds in his trading account to bring the equity level back up to the initial margin level. This request for additional funds is referred to as a margin call. Any profits over the initial margin requirement may be withdrawn or used as margin for other futures contracts. The determination of the account equity is done by the clearing house at the end of every trading day using futures settlement prices. That is, the trader's position is marked-to-market daily. Any request for additional margin must be deposited into the account by the following morning, or else the futures positions may be closed.
Lack of control of leverage is the single leading cause of financial death among beginning futures traders because most tend to "bite off more than they can chew". Since with a little money, one can control a lot of product, net profit or loss can quickly become significant relevant to one's initial margin. This can, in turn, make him very rich or very poor in a short space of time. It is important, therefore, to control leverage.
For example, in Spring of 1994, June live cattle futures plunged $11 per hundredweight (cwt) over 32 trading days as the number and weight of cattle on feed increased. A trader who sold one June cattle futures contract at $74 per cwt having initial margin of $700 earned close to $4,400 as prices fell to $63 per cwt ($11 gain per cwt x 400 cwt) for a return of 628% on the initial investment in little more than a month. On the other side, a trader who had purchased cattle futures over this time period would have lost around $4,400 per contract.
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