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How Does Margin Work?

Trader Education Managing Director Joe Mazzola examines two required account deposits – the initial and maintenance margins.

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One of the great draws of trading futures is that, compared to other financial products, you can control a large position with a relatively small amount of your own money.

 

In fact, futures contracts can be opened with a good faith deposit, known as the ”initial margin,” usually in the range of just 3 to 12% of the contract’s full value.

 

Now once you’ve opened your position, there is a second type of margin, the maintenance margin. As its name suggests, the maintenance margin is the amount you must maintain in your account at all times.

 

It is set by the exchange at a point somewhat lower than the initial margin, to allow for some market fluctuation.

 

And if the funds in your account drop below the maintenance margin, your brokerage firm will require you to deposit more money right away.

 

For example –

 

If you want to speculate on interest rates, you can trade a futures contract that controls $100,000 of a long-term U.S. Treasury Bond.

 

With the initial margin set at 4%, you can take a $100,000 position for $4,000.

 

A 4% rise in bond prices makes your contract worth $104,000. 

 

You’ve made $4,000 on a $4,000 investment – that’s a 100% return.

 

But what if bond prices go down by 4%?

 

You’ve now lost $4,000 – that’s your entire investment.

 

And, because the funds in your account are now below the maintenance margin, you will receive a margin call.

 

A margin call requires you to add funds to your account, or reduce your positions to get back to the initial margin level.

 

If you don’t, the brokerage may liquidate your positions to get your account back in balance.

 

Being able to get into a trade with such low margin has obvious benefits, but, as you can see, substantial risks as well.

 

For more on managing risk when trading futures, watch the next video.

 

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