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Many traders are drawn to futures because of leverage. Leverage allows traders to commit a smaller amount of capital to control the value of a large asset. This means that smaller changes in the underlying price can translate into larger gains or losses. In futures trading, this leverage is made possible by trading on margin. Margin is the amount of funds required to enter a futures position, which is usually a fraction of the contract's total value.
Margin for futures is different than margin for stocks. In stocks, you borrow against your assets like a loan. In futures, you put down a good faith deposit called the initial margin requirement. It's important to note that gains or losses on futures positions could exceed the initial margin requirement. Understanding margin is essential for a futures trader, so let's look at an example.
Let's say Trader A is bullish on the S&P 500® and decides to take a long position on the E-Mini S&P 500 Index futures, or forward slash ES.
For this example, we'll say that ES is trading at 2,800, which is a notional value of $140,000. Notional value is the cash equivalent value to owning the underlying asset or the contract's total value. In other words, if you wanted to buy a portfolio that reflected the S&P 500 with the same value as an ES contract, you'd have to invest $140,000.
However, by using a futures contract, Trader A can put down a fraction of the contract's $140,000 notional value. Margin is set by the futures exchange and is typically 3% to 12% of the contract's notional value. Some brokers may choose a higher requirement; therefore, initial margin can change at any time.
In this example, let's say the initial margin requirement is $5,500 for Trader A plus commissions and exchange fees.
There are two margins she needs to be aware of when trading futures. In addition to initial margin, there's also maintenance margin. Maintenance margin is lower than initial margin. Typically, the initial margin requirement will be 110% of the maintenance margin requirement. When traders first enter a futures position, they need to put up the initial margin requirement. However, after establishing the position, traders are held to the maintenance margin requirement.
For this example, Trader A has an initial margin of $5,500, her maintenance margin is $5,000, and her account balance is also $5,500.
The cash for the initial margin is automatically set aside in her account once the order is entered.
Trader A's buy order is routed to the exchange and is connected with Trader B's sell order.
Trader B is bearish on the S&P 500 and shorts an ES contract. Trader B also puts up the initial margin of $5,500 because the buyer and the seller put up the same initial margin.
Let's check the numbers for Trader B. He also has an initial margin requirement of $5,500 and is held to the maintenance margin of $5,000—the same as Trader A. For this example, we'll say his account balance is $5,500.
The next day the S&P 500 fell five points. Let's see how this affects our traders.
Each point on the ES is equal to $50. So, with the S&P 500 falling five points, Trader A loses $250, while Trader B gains $250. To understand what this does to each trader's balance, let's discuss settlement.
At the end of each trading day, futures trades are settled, or what's called marked-to-market. This is where the daily gains or losses are credited or subtracted from the account. Traders who experience a loss will incur a cash debit to their account, and traders who experience a profit will receive a cash credit. Because Trader A lost $250, her account was debited, reducing her account balance to $5,250.
Trader B profited $250 and was credited the profits so his account balance grew from $5,500 to $5,750.
The next day the S&P 500 continued to slide and lost another 10 points, or $500. Because Trader A lost another $500 after settlement, her account fell to $4,750, which is below the maintenance margin of $5,000.
Because Trader A's account balance is below the maintenance margin requirement, she is issued a margin call. In order for Trader A to stay in the trade, she must bring her account balance back up to the initial margin requirement of $5,500. This could include depositing more money, closing the position, or having her existing position appreciate.
Trader B is pretty happy with his trade so far. He just gained another $500, raising his account balance to $6,250.
The next day the S&P 500 rallied 20 points. Trader A's account increased by $1,000 and is now at $5,750. Her account balance is back above the initial margin requirement, which means she satisfied her margin call. Remember, if her position didn't appreciate in value, she'd have been required to add funds or close her position. Trader B's account balance went from $6,250 to $5,250.
To end our example, let's say that both traders closed their trades before expiration. Let's see how each trader fared.
Trader A's account started at $5,500 and ended with $5,750 for a return of 4.5%.
Trader B started with $5,500 and ended with $5,250 for a loss of 4.5%.
You can see how quickly profits and losses on a futures trade can change with just small moves in the underlying index. Remember, gains or losses on futures positions may exceed the initial margin requirement. But now that you've seen how margin works, you can better anticipate potential outcomes and plan accordingly.
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