Trading on Margin Basics for Futures and Options - dummies

Trading on Margin Basics for Futures and Options

Margin is what makes futures trading so attractive, because it adds leverage to futures contract trades. The downside is that if you don’t understand how trading on a margin works, you can take on some big losses in a hurry.

You can reduce the risk of buying futures on margin by

  • Trading contracts that are lower in volatility.

  • Using advanced trading techniques such as spreads, or positions in which you simultaneously buy and sell contracts in two different commodities or the same commodity for two different months, to reduce the risk. An example of an intramarket spread is buying March crude oil and selling April crude. An example of an intermarket spread is buying crude oil and selling gasoline.

Trading on margin enables you to leverage your trading position. This means that you can control a larger amount of assets with a smaller amount of money. Margins in the futures market generally are low; they tend to be near the 10 percent range, so you can control, or trade, $100,000 worth of commodities or financial indexes with only $10,000 or so in your account.

Trading on margin in the stock market is a different concept than trading on margin in the futures market. In the stock market, the Federal Reserve sets the allowable margin at 50 percent, so to trade stocks on margin, you must put up 50 percent of the value of the trade.

Futures margins are set by the futures exchanges and are different for each different futures contract. Margins in the futures market can be raised or lowered by the exchanges, depending on current market conditions and the volatility of the underlying contract.

Generally, when you deposit a margin on a stock purchase, you buy partial equity of the stock position and owe the balance as debt. In the futures market, a margin acts as a security deposit that protects the exchange from default by the customer or the brokerage house.

When you trade futures on margin, in most cases you buy the right to participate in the price changes of the contract. Your margin is a sign of good faith, or a sign that you’re willing to meet your contractual obligations with regard to the trade.