One of the most appealing features of futures trading is the ability to trade big contracts with a relatively low initial investment, which is known as leverage. To do this, traders use margin, which is taking out loans against existing cash and securities to provide money for trades. To take full advantage of leverage, traders must first understand initial and daily margin requirements.
Futures trading is generally an active trading strategy -- traders buy and sell based on price movements, and those movements are sometimes small. To make real money traders need to buy big, so that those small movements add up to a lot of money. Trading large futures contracts with cash is impractical -- most people can't tie up hundreds of thousands of dollars in one trade. Borrowing on margin solves this problem by allowing traders to borrow money to buy high, then pay the debt off when they sell low.
To secure a margin loan, investors deposit cash and securities into their accounts to serve as collateral. The cash value of these assets is the margin available for borrowing at any given time. Brokerage firms demand that the margin is kept equal to a percentage of the trader's loan. This can vary depending on the market value of what the trader holds at any time, along with individual futures contract's risk and volatility.
When a trader makes an initial futures contract purchase, the brokerage firm requires an initial margin, which is collateral equal to a percentage of the market value of the contract. The exact initial margin percentage is based on a number of factors, such as prior trading activity, current holdings, and perceived risk. Once futures contracts are purchased, the brokerage firm requires a day margin, which is the total amount of collateral based on everything held in the account from day to day. This is usually, but not always, lower than the initial margin.
If a trader does not meet the value of required initial margin, the brokerage firm will not allow the trade. If margin collateral does not meet the day margin requirement, there is a margin call. The trader must sell contracts or add assets to meet the margin within a set period of time. If a trader does not maintain the day margin, the brokerage firm can sell contracts, suspend trading privileges or both.
Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Her clients include The Motley Fool, Proctor and Gamble and NYSE Euronext.