Margin on Futures Contracts

 
 
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 Introduction | A futures trading example | Return to Market Risk Management page
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Introduction

The buyer or seller of a futures contract is required to deposit part of the total value of the specified commodity future that is bought or sold. This is known as margin money. This deposit is required by regulations set out by each commodity exchange, and must be deposited with a registered futures commission merchant (RFCM) before a futures contract is bought or sold. Margin money is essentially a guarantee that the trader, the customer of the RFCM, will honor the contract.

There are two levels of margins - the initial margin and the maintenance margin. The minimum amount of the initial margin is set by the exchange and varies, depending on the commodity, the commodity's trading price, and how much those prices move up and down. Exchanges may increase or decrease initial margin amounts at any time. RFCMs usually set initial margins higher than the minimums set by the exchange.

The maintenance margin is the minimum amount of money that must be maintained in a margin account after all potential losses have been accounted for.

ICE Futures Canada Minimum Margins, Effective December, 2014
Commodity
For One 20-tonne Contract, Buy or Sell
Initial Margin
Maintenance Margin
Barley (BW)
$220
$200
Canola (RS)
$550
$500
Durum Wheat (DW)
$2,200
$2,000
Milling Wheat (WA)
$1, 650
$1,500

If a change in the futures contract price causes the open futures trade to be in a losing position, a "margin call" may be required by the broker, even though the position has not been offset. A margin call is required once an account's initial margin has been reduced to below the maintenance margin level. If this happens, the client must deposit enough money to re-establish adequate margin in the account. If arrangements are not made to meet the margin call immediately, the trader's commodity broker may make an offset trade to terminate the client's futures position. Brokers will offset a position to protect the brokerage firm, which is legally responsible to cover losses if a trader does not cover the losses.

For example, Client A buys one barley futures contract (20t) for $248 per tonne. Client A posts an initial margin of $220 with the broker. If, the next day, the price of that barley contract goes down by 6 dollars a tonne to $242, Client A has a potential loss of $120 (20 tonnes X $6). Client A's margin account has been reduced by the $120 potential loss to only $100. To bring Client A's account back to the required margin level, the commodity broker asks the client to send $120 to bring the margin account up to the $220 initial margin level. This is known as a margin call.

Margin call example:

June 3: Client A buys one Dec. barley contract (20 tonnes) @ $248/t. Initial Margin $220
June 4: Dec. barley futures price falls to close at $242/t
June 4: Potential Loss (if offset) $6.00/t
Total Potential Loss (20t X $6.00) = -$120
June 4: Margin Account Value is $100 after accounting for potential loss
June 4: Margin Call (phone call) from broker for $120
June 5: Margin Call Made (money sent to broker) $120
June 5: Margin Account Value $220

Remember that, if this barley futures trade is a hedge (such as a cattle feedlot operator protecting against a rising price of barley), the potential loss in the futures trade as the barley futures price fell would likely be offset with a lower cash price for barley needed by the feedlot.

A Futures Trading Example

In mid-June, a speculator expects canola prices to rise over the next few months, based on his belief that the upcoming crop will be smaller than most people expect. Through a commodity broker, he buys 100 tonnes of November canola futures (i.e., 5 X 20t contracts) using the ICE exchange at $460 per tonne. This buy is known as taking a long futures position. Remember that, since futures contracts are margin transactions, the speculator only needs to put up a fraction of the total value of the contract. The initial margin would be $2750 for the five contracts, which have a value of $46,000 ($460/tonne X 100 tonnes).

In early July, November canola futures are trading at $480 per tonne and the speculator decides to take profits ($20 per tonne) and instructs his broker to sell 100 tonnes of November canola futures. The new short (sell) position offsets the original long (buy) obligation. What remains is to square up any gains or losses from price changes since the futures position was opened. In this example, the speculator bought 100 tonnes of November canola at $460 per tonne, and later sold 100 tonnes at $480 per tonne for a gross gain of $20 per tonne. From this gross sum, broker commissions must be paid. There were no margin calls because prices moved only in a favorable direction.

June 10: initial margin deposit with broker of $27.50/t ($2750)
June 10: buy 5 contracts (100t) Nov Canola at $460/t
July 7: sell (offset) 100 t Nov Canola (5 contracts at 20t) at $480/t
Gross Profit $20/t for a total of $2000
July 7: Funds returned to trader: $20/t (profit) - $1.25/t (Example broker commission) = $18.75/ton or $1875 plus the original margin deposit of $2750 released (or refunded on request).

The trader earned $1875 for their speculative activity.

In summary, margin money is a deposit to secure a futures position while it is open. Margins must be maintained at the level required by the brokerage firm. When the futures position is closed, the remaining margin money after trade settlement can be returned to the account holder.
 
 
 
 
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For more information about the content of this document, contact Neil Blue.
This document is maintained by Erminia Guercio.
This information published to the web on October 25, 2012.
Last Reviewed/Revised on January 15, 2015.