What Are Margins?

The primary benefit to trading futures, and indeed any derivative for that matter, is the advent of leverage. Leverage allows the trader to escalate the size of a given trading position by many multiple times, allowing for even small price movements to bring considerable percentage gains (and losses). The rationale underpinning leverage is that by borrowing the funds for a larger transaction and repaying in one lump sum on the sale of the assets, the difference can present a higher return on investment than a pound-for-pound investment with less upfront capital.

But of course, leverage isn’t just free, for the trader to cover any size transaction, and as with most forms of finance there is a requirement for some form of security to be paid in respect of the transaction. That security portion is known in the trading lingo as margin.

Margin is effectively the amount of money you need to put down in order to fund a larger transaction size, and is designed to give the broker providing the leverage a buffer in respect of losing positions. Margin is usually expressed as a percentage of the total transaction amount, and is rolling in the sense that traders are often required to top-up following a margin call, or surrender their position and accept their losses.

Broadly, margin can be considered as an umbrella term for a number of different specific types of security relating to different underlying assets. While the individual definitions and specifications vary, generally speaking, margin is used to secure the leverage portion of the transaction and to prevent the broker from sustaining considerable losses from traders in default.

But with futures contracts margins work both ways, requiring the seller to pay a portion in security in respect of the delivery of the assets upon maturity of the futures contract. In order to guarantee that the selling party can adhere to their obligations in relation to the futures contracts they’ve sold, they are also required to have sufficient capital in place, in the form of either cash or bonds, to act as security for the transaction value. As many futures are cash-settled anyway, this is simply a mirror-image obligation of that of the trader in respect of ensuring their account remains sufficiently liquid to fund a portion of the transaction in the event of default.

It’s also worth bearing in mind that compared to other forms of investment finance, say for example leveraged forex transactions, the margin requirements for futures contracts are remarkably low as a percentage of the total contract values available.

Consider a 10% ($100) margin on $1,000 worth of futures contracts. In actuality, that $1,000 worth of futures contracts might concern $10,000 worth of asset, in which case a 1% movement in the top asset price would filter down as a higher percentage return at each stage of the leverage pyramid. This means that, in effect, the margin required to give access to $10,000 worth of assets is actually just 1% – that leaves 99% of the transaction to be funded by the leveraged portion, while you keep 100% of the gains.

Margin is a simple concept that is so often overcomplicated by those in the trading game. It’s simply about making sure you can afford to cover the costs of your open positions heading south, while providing the safe, secure trading environment that’s absolutely essential to the effective and smooth operation of the futures exchanges.

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