One of the unique characteristics of commodity futures contracts is the ability to trade with margin. If you’ve ever traded stocks, you know that margin is the amount of borrowed money you use to pay for stock. Margin in the futures markets is slightly different than stock market margin.
In the futures markets, margin refers to the minimum amount of capital that must be available in your account for you to trade futures contracts. Think of margin as collateral that allows you to participate in the futures markets.
Initial margin: The minimum amount of capital you need in your account to trade futures contracts
Maintenance margin: The subsequent amount of capital you must contribute to your account to maintain the minimum margin requirements
Margin requirements are established for every type of contract by the exchange on which those contracts are traded. However, the futures broker you use to place your order may have different margin requirements. Make sure you find out what those requirements are before you start trading.
In the stock market, capital gains and losses are calculated after you close out your position. In the futures market, capital gains and losses are calculated at the end of the trading day and credited to or debited from your account.
If you experience a loss in your positions on any given day, you receive a margin call, which means that you have to replenish your account to meet the minimum margin requirements if you want to keep trading.
Trading on margin provides you with a lot of leverage because you need to put up only relatively small amounts of capital as collateral to invest in significant dollar amounts of a commodity.
For example, if you want to trade the soybean futures contracts on the CME, the initial margin requirement is $1,100. With this small amount, you can control a CME soybeans futures contract that has a value of approximately $28,400 (5,000 bushels at $5.68 per bushel)! This translates to a minimum margin requirement of less than 4 percent!
Margin is a double-edged sword because both profits and losses are amplified to large degrees. If you’re on the right side of a trade, you’re going to make a lot of money. However, you’re also in a position to lose a lot (much more than your initial investment) if things don’t go your way. Knowing how to use margin properly is absolutely critical.