When you trade futures, you need to make an initial performance bond – or margin – deposit with a futures broker, which in turn is held at the exchange’s clearing house. A performance bond simply is a good-faith deposit to assure that there is enough money in your account to cover any losses.
Minimum performance bonds are based on a percentage of a contract’s underlying value, and are determined by the exchange. That’s usually only a relatively small fraction of the total value of the position being traded, typically between about 5 and 15%. (Show me how this differs from stock margins link; see bottom of document)The amount required for a performance bond varies according to the volatility of the product being traded – the more volatility, the larger the performance bond. This ensures that the performance bond will cover maximum losses that a contract could incur in a single day.
Also, your brokerage firm can determine if it needs to increase performance bonds from exchange minimums, and some do.
Performance bonds in futures are unique, and they protect both you and the integrity of the industry because trading losses are not allowed to accumulate from day to day. And, of course, traders can withdraw profits. At the end of each trading day, the exchange identifies the current price for each contract. Your account is credited or debited based on that day's gains or losses according to that price. This is known as “marking to the market.” (“Show me how Mark to the Market Works” link to Lerman example; see bottom of document) This is different that in the stock market where price settlement in done in three days.
Futures accounts that drop below the amount of deposit required must add money to bring the account back up to the minimum performance bond. Until they do, a trader is not allowed to continue trading. To make sure that debts don’t accumulate, accounts that are unable to meet the minimum may be closed. Traders can withdraw money above the performance bond level if they wish, but must always maintain the minimum performance bond required by their brokerage firm.
One of the reasons performance bonds are so important is because leverage in futures is high. In other words, the amount of money you commit relative to the actual underlying value of the contract is quite low, generally between 5 and 15% of the actual value of the contract. But because futures are highly leveraged -- a very nice advantage – the effect of price changes is also magnified. You can lose more than the amount of money you've deposited for a futures position. So use only funds you can afford to lose without affecting your lifestyle. And only a portion of these funds should be devoted to any one trade because you can’t expect to profit on every trade.
The Basics Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. By law, your broker is required to obtain your signature to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin. Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It's essential to know that you don't have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.
You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid. Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a margin call. We'll talk about this in detail in the next section.
Borrowing money isn't without its costs. Regrettably, marginable securities in the account are collateral. You'll also have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.
Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.
Not all stocks qualify to be bought on margin. The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers will not allow customers to purchase penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the day-to-day risks involved with these types of stocks. Individual brokerages can also decide not to margin certain stocks, so check with them to see what restrictions exist on your margin account.