5) Futures Fundamentals: Characteristics
In the futures market, the definition of margin is different from how it is defined in the stock market. Here, margin is the initial deposit of “good faith” made into an account in order to enter into a futures contract. It is called good faith because it is the money that is used to debit losses if there are any.
The futures exchange will determine a minimum amount of money that you must deposit into your account when you open a futures contract. This is called the initial margin. It is usually at 5% to 10% of the futures contract, but it can be higher during high market volatility. A refund of the initial margin plus or minus any gains or losses, respectively, will be given when the contract is liquidated. The amount in your margin account changes from day to day as the market fluctuates in relation to your futures contract.
The the lowest amount an account can reach before there is a need to replenish is known as the maintenance margin. When the account drops lower than the maintenance margin, brokers can issue what is called a margin call. This means that the investor will have to put in more funds to bring the account back up to the initial amount. Usually, when a margin call is made, the funds have to be delivered quickly. If not, the brokerage has the right to liquidate your position completely in order to make up for losses incurred on your behalf.
Leverage: The Double-Edged Sword
Leverage means having control over large cash amounts of commodities with comparably small levels of capital. For a smaller amount of cash, you can enter into a futures contract that will be worth more than what you have to pay initially. It is a known fact that in the futures market, price changes are highly leveraged, which means that even a small shift in price could become a huge gain or loss.
The reason why futures positions are highly leveraged is because the initial margins set are comparatively smaller than the cash value of the contracts. The smaller the margin in relation to the cash value of the futures contract, the higher the leverage.
A highly leveraged investment can produce either of two results: great profits or greater losses. The futures market can be very risky and is not advised for those who can’t stomach it.
Because of leverage, if the price of the futures contract moves up even a little bit, the gain will be huge compared to the initial margin. The same can be said inversely if the price moves downward. For example, you buy a futures contract with a margin deposit of $15,000 with an index at 1400. The value is worth $300 multiplied by the index ($300 x 1400 = $420,000). This means that for every point gain or loss, $300 will be gained or lost.
After two months, the index went up by 10%, or a 140-point gain to stand at 1540. If we translate this, you would have earned $42,000 (140 points x $300).
Let us say that the the index dropped by 10% instead. It would mean a loss of $42,000 where you have to pay $27,000 out of your own pocket to cover the losses ($42,000 – $15,000). The thought that a change of 10% can result in such a large gain or loss is the risky arithmetic of leverage. Futures tend to have extreme profits or losses because of the low margins and high leverage.
Pricing and Limits
Contracts in the futures market is a direct result of competitive price discovery. Prices are quoted as they are in the cash market: in dollars, cents, or per unit (ounce, bushels, barrels, etc.).
Prices in a futures contract have a minimum amount that they can move. These minimums are called “ticks.” It is set by the futures exchange. For example, a bushel can move up or down at a minimum sum of a quarter of one U.S. cent. For a wheat contract for 10,000 bushels, the minimum price movement would be $25 ($0.0025 x 10,000).
There is also a price change limit in futures prices. This determines the prices by which the contracts can trade on a daily basis, or an upper and a lower price boundary. To get the upper and lower boundaries, the price change limit is added to and subtracted from the previous day’s close.
To illustrate, say the price change limit on aluminium per ounce is $0.25. The previous day saw aluminum close at $4 per ounce. Today, the upper boundary for silver would then be $4.25, while the lower boundary would be $3.75. When the prices of futures contracts reach either of the boundaries for aluminum, the exchange stops all trading of this commodity for the day. Trading is only continued the next day. There are times where it is not possible to liquidate a futures position because limits have been reached for the day.
The price limit can be revised by the exchange if deemed necessary. It is common for the futures exchange to eliminate daily price limits in the month that the contract expires (delivery or “spot” month). This is due to the volatility of trading during that month where sellers and buyers are trying to obtain the best possible prices before the contract expires.
For a fair market, such that no single person controls the price for a specific commodity, the CTFC and the futures exchanges impose limits on the total amount of contract or units of a commodity per person. This is called a position limit.