Margin and Leverage in Futures

Why this matters

What Futures Are ended with a wheat contract worth $30,000 that nobody pays $30,000 to hold. What they pay instead, and how the system makes sure losses are covered, is what turns futures from a farmer's tool into one of the most leveraged things an individual can trade. The US regulator's own advice is blunt: speculating in commodity futures and options is a volatile, complex, and risky venture that's rarely suitable for individual investors, and many individuals lose all their money and can be required to pay more than they invested.¹ This lesson shows the mechanism behind both halves of that sentence.

Margin is a deposit, not a down payment

Futures traders aren't required to pay the entire value of a contract. They post margin, typically between 2% and 10% of the contract's value. Futures margin isn't a down payment, as margin on shares is. It's a performance bond, there to make sure the trader can meet their obligations.²

The difference from Margin and Short Selling matters. A share bought on margin is partly paid for with a loan from the broker, and the loan carries interest. A futures buyer hasn't bought anything yet and hasn't borrowed anything. Both sides of a futures contract post margin, the buyer and the seller alike, because both have promised something.

Two levels are set.²

• Initial margin is the amount, specified by the exchange or the clearing house, that has to be posted to open a position.
• Maintenance margin is a level at or below the initial margin. If the account falls below it, the trader must post additional money, called variation margin, to bring it back up to the initial level.

Brokers, known in this market as futures commission merchants, often require customers to keep more than the exchange's minimum.²

Settled every day

After a position is opened, it's marked to market daily. When the position loses value, money comes out of the margin account. When it gains, money goes in.² The CFTC requires customer accounts to be adjusted to each trading day's market value at the close.¹ A futures loss doesn't wait for the position to be closed. It's paid, in cash, that evening.

The contract covers 5,000 bushels, worth $30,000. Initial margin is $2,000 and maintenance margin is $1,800. Each cent the price moves is $50.

Day	Closing price	Day's gain or loss	Account before any call	Margin call paid in	Total deposited
Open	$6.00		$2,000		$2,000
1	$5.96	−$200	$1,800		$2,000
2	$5.90	−$300	$1,500	$500	$2,500
3	$5.95	+$250	$2,250		$2,500
4	$5.84	−$550	$1,700	$300	$2,800
5	$5.70	−$700	$1,300	$700	$3,500
6	$5.78	+$400	$2,400		$3,500

Wheat fell 3.7% over six days, and the trader had to send money three times. They've deposited $3,500 to hold a position that has lost $1,100, and the account holds $2,400. Each call came the day after a loss, and each had to be met before the next day's trading.

What a margin call does

A trader who can't meet a call is closed out. Suppose the trader above had only the original $2,000 to spare. On day 2 they can't pay the $500, and the broker sells the contract at $5.90. The loss of $500 is now final. On day 6 wheat is back to $5.78, and if it went on to $6.20 the next week, the trader would have been right about wheat and still have lost money, because they couldn't afford to stay in.

FINRA's description of margin in commodity investing makes the same point: in a margin call an investor may have to add money to prevent the position from being liquidated without their consent or prior notice.³ Daily settlement is what protects the clearing house. The price of that protection is that a trader needs cash on hand to survive the path, not just to be right about the destination.

The rest of this lesson is for members

Still to come in this lesson: How leverage scales the result, Measuring the real size of a position, Where the money sits, the key takeaways, and 2 quiz questions with explanations.

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