Understanding Margin Requirements

Futures contracts are considered a fairly low risk form of investment that can be made on the exchange market. One reason for the relatively low risk of futures contracts is the fact that traders are required to post margin, which is also referred to as a performance bond, on the exchange. This amount is typically anywhere from 5 to 15% of the value of the contract.

In some cases, the margin requirements may actually be reduced or waived completely. This option is generally reserved for hedgers that physically own the covered commodity or for spread traders that have established offsetting contracts that balance the position.

One type of margin that may be utilized with futures contracts is the initial margin. This type of margin is paid for by both the seller and the buyer and is representative of the loss that was experienced on the contract. This loss is determined by the price changes that have historically taken place. On a typical day of trading, this amount is not likely to be exceeded.

Since a futures account is marked to market on a daily basis, it is easier to monitor its progress. Therefore, if the margin manages to drop below the established margin maintenance requirement that was established through the exchange listing, a margin call is issued in order to increase the account to its required amount.

Speculators use what is referred to as a margin-equity ratio in order to help them determine the investments they will make. The margin-equity ratio represents the amount of the trading capital being held as the margin at a specified time. In the case of low margin requirements, a great deal of leverage in the investment is obtained. It is important to keep in mind, however, that exchanges do require a minimum amount and that this amount varies according to the trader and the contract. Therefore, while the broker may set a higher requirement, he or she cannot set it to be lower. A trader, on the other hand, can set it to be even higher if he or she doesn’t want to deal with margin calls.

The return on margin, which is referred to as ROM, is also used to help make a judgment on the performance of the futures contract. This is because the ROM represents the gain or loss as it compares to the perceived risk as determined by the exchange. This risk is reflected in required margin and the ROM may be calculated by dividing the realized return by the initial return. Therefore, an Annualized ROM is actually equivalent to (ROM+1)(year/trade_duration)-1.

Understanding margin requirements and how the posted information can be used to make predictions and judgmentes is an important component of investing in futures contracts. In this way, you can make a wise investment that is even more likely to provide you with a greater return to your investment.

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