Trading more with less
Learn margin, leverage effects & risk management in futures.
Introduction
As Theodore delves deeper into futures trading, he encounters the concept of margin.
Margin in futures trading refers to the initial deposit required to enter a futures position, serving as a performance bond rather than a down payment.
Unlike securities margin accounts, futures margin ensures traders can cover potential losses.
Understanding margin is crucial, as it affects how traders allocate capital and manage risk exposure in the volatile futures markets.
Initial and Maintenance Margin
Exchanges set initial margin requirements, the minimum amount a trader must deposit to open a position.
They also establish maintenance margins, the minimum account balance that must be maintained.
If the account falls below this level due to adverse price movements, a margin call is issued, requiring additional funds.
Failure to meet a margin call can result in the liquidation of positions.
These requirements ensure traders have sufficient capital to cover potential losses.
Theodore Faces Margin Requirements
Theodore buys ten steel futures contracts, each requiring a $5,000 initial margin, totaling $50,000.
This allows him to control $650,000 worth of steel (at $65,000 per contract).
When steel prices drop by $10 per ton, his positions lose $100,000 collectively.
His account falls below the maintenance margin, triggering a margin call for an additional $20,000.
Scrambling to meet the call strains his cash flow, forcing him to divert funds from operations.
He realizes margin requirements must be carefully managed.
Mechanics of Leverage
Leverage in futures trading arises because only a small margin is required to control a large contract value.
This amplifies both gains and losses, small price movements can lead to significant profit or loss relative to the margin deposited.
Leverage ratio is calculated by dividing the total contract value by the margin requirement.
For example, a $100,000 contract with a $5,000 margin has a leverage ratio of 20:1. Understanding leverage is vital for managing potential risks and rewards.
Theodore Experiences Leverage Effects
Investing $50,000 in margin to control $500,000 worth of steel futures (a 10:1 leverage), Theodore profits $10,000 when prices rise 2%, a 20% return on his initial investment.
Buoyed by success, he doubles his position.
However, a subsequent 1% price drop results in a $10,000 loss per initial position, totaling $20,000, wiping out previous gains and reducing his margin account to $30,000.
Shocked by how quickly losses accumulate, Theodore learns leverage can amplify losses as much as gains.