To say that gains and losses in futures trading are the result of price changes is an accurate explanation but by no means a complete explanation. Perhaps more so than in any other form of speculation or investment, price changes in futures trading are highly leveraged. An understanding of this leverage—and how it can work to either your advantage or disadvantage—is absolutely essential to an understanding of futures trading.
As mentioned in the introduction, only a relatively small amount of money (known as margin) is required in order to buy or sell a futures contract. On a particular day, a margin deposit of only $2,500 might enable you to purchase or sell a futures contract on $100,000 worth of U.S. Treasury Bonds. Or for an initial margin deposit of about $15,000 you might buy or sell a contract covering common stocks currently worth $300,000. Or for around $4,000 you may be able to buy or sell a futures contract on 37,000 pounds of coffee currently worth $40,000. The smaller the margin in relation to the underlying value of the futures contract, the greater the leverage.
If you speculate in futures contracts and the price moves in the direction you anticipated, high leverage can yield large profits in relation to your initial margin deposit. But if prices move in the opposite direction, high leverage can produce large losses in relation to your initial margin deposit. Leverage is a two-edged sword.
For example, assume that in anticipation of rising stock prices you buy one June S&P 500 stock index futures contract at a time when the June index is trading at 1200. Also assume your initial margin requirement is $15,000. Since the value of the futures contract is $250 times the index, each one point change in the index represents a $250 gain or loss.
An increase of five percent in the in dex, from 1200 to 1260, would produce a $15,000 profit (60 X $250). Conversely, a 60 point decline would produce a $15,000 loss. In either case, an increase or decrease of only five percent in the index would, in this example, result in a gain or loss equal to 100 percent of the $15,000 initial margin deposit! That's the arithmetic of leverage.
Said another way, while buying (or selling) a futures contract provides the same dollars and cents profit potential as owning (or selling short) the actual commodity covered by the contract, low margin requirements sharply increase the percentage profit or loss potential.
Futures trading thus requires not only the necessary financial resources but also the necessary financial and emotional temperament. It can be one thing to have the value of your common stock portfolio decline by five percent but quite another, at least emotionally, to have that same five percent stock price decline wipe out 100 percent of your investment in futures contracts.
An absolute requisite for anyone considering trading in futures contracts—whether it's stock indexes or sugar, pork bellies or petroleum—is to clearly understand the concept of leverage. Calculate precisely the gain or loss that would result from any given change in the futures price of the contract you would be trading. If you can't afford the risk, or even if you're uncomfortable with the risk, the only sound advice is don't trade. Futures trading is not for everyone.
Margins
As is apparent from the preceding discussion, the arithmetic of leverage is the arithmetic of margins. An understanding of the different kinds of margins is essential to an understanding of futures trading.
If your previous investment experience has mainly involved common stocks, you know that the term margin—as used in connection with securities—has to do with the cash down payment and money borrowed from a broker to purchase stocks. But used in connection with futures trading, margin has an altogether different meaning and serves an altogether different purpose.
Rather than providing a down payment, the margin required to buy or sell a futures contract is a deposit of good faith money that can be drawn on by your brokerage firm to cover any day-to-day losses that you may incur in the course of futures trading. It is much like money held in an escrow account. When you liquidate a futures position, your margin deposit is refunded to you, plus any undistributed profits or minus any uncollected losses on the trade.
Minimum margin requirements for a particular futures contract at a particular time are set by the exchange on which the contract is traded. They are typically five to 10 percent of the value of the futures contract. Exchanges continuously monitor market conditions and risks and, as necessary, raise or reduce their margin requirements. An increase in market volatility and the range of daily price movements is frequently a reason for raising margins.
Note that the exchanges' minimum margin requirements are exactly that: minimums that exchange-member brokerage firms must charge. Individual firms may have margin requirements higher than the exchange minimums.
There are two margin-related terms you should know: Initial margin and Maintenance margin.
Initial margin (sometimes called original margin) is the sum of money that you must de posit at the outset with the brokerage firm for each futures contract to be bought or sold. On any day that profits accrue to your open positions, the profits will be added to the balance in your margin account. On any day losses accrue, the losses will be deducted from the balance in your brokerage account.
If and when the funds remaining in your account are reduced by losses to below a certain level—known as the maintenance margin level—your broker will require that you deposit additional funds to bring the balance back to the level of the initial margin. Or you may be asked for additional margin if the exchange or your brokerage firm raises its margin requirements. Requests for additional margin are known as margin calls.
Assume, for example, that the initial margin needed to buy or sell a particular futures contract is $2,000 and that the maintenance margin is $1,500. Should losses on open positions reduce the funds remaining in your trading account to $1,400 (an amount less than the maintenance requirement), you will receive a margin call for the $600 needed to restore your account to $2,000.
Before trading in futures contracts, be sure you understand your particular brokerage firm's Margin Agreement and how and when the firm expects margin calls to be met. Some firms may require only that you mail a personal check. Others may insist you wire transfer funds from your bank or provide same-day or next-day delivery of a certified or cashier's check. If margin calls are not met in the prescribed time and form, the brokerage firm can protect itself by liquidating your open positions at the available market price (possibly resulting in an unsecured loss for which you would be liable).
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