Margin is essentially a loan that a brokerage firm extends to a client (the trader or investor) that is used for the purchase of trading instruments. Margin trading allows traders and investors to enter larger positions then they would otherwise be able to with a cash account because it provides leverage. This leverage amplifies both wins and losses and, as such, margin should be used with caution and consideration. In addition to the leverage afforded, margin gives traders the ability to sell short. When traders sell short, they are attempting to profit from falling prices. Selling short requires traders to begin a trade by borrowing shares or contracts from a broker (using margin) and then selling them. Traders buy back the shares or contracts (known as "buying to cover") when they wish to close the trade.
The concept of margin differs between stock, forex and futures because stock and forex trading involves purchasing something tangible (a part of a company and a foreign currency) and futures trading involves buying or selling a contract whose obligation will be met at a future date. Margin for stock and forex trading is defined as borrowed money, whereas futures margin is considered an initial deposit or an "earnest money" deposit. Margin account holders pay interest on the amount of money used as margin. The margin interest rates vary depending on the current "broker call rate" or "call money rate" and the amount that is borrowed.
Brokerage firms require a minimum amount of funds in an account, or minimum margin, for traders to be able to use margin. The minimum margin requirements for futures contracts, known as performance bonds, are set by the exchanges that offer these contracts. These minimums change frequently in response to market activity. The minimum margin requirements change in response to events such as:
- Changing volatility
- Shifts in supply and demand
- Changes in fiscal policy
- Major geopolitical events
- Natural disasters
Initial margin is the margin that traders must pay for with their own money when initiating a position. Also known as futures requirement, these rates vary by contract, contract date and brokerage firm. Initial margin is a percentage of the full contract value of a position and is used to ensure that traders have enough cash in their accounts to cover losses.
Maintenance margin is the minimum value that must be maintained in a margin account. As an example, imagine that a trader entered a position to buy (go long) the September 2012 ES when the contract was trading at 1355.00 points. Imagine also that the exchange (CME) required an initial margin of $4,500 to trade the contract, with a maintenance margin of $3,500. If price fluctuations in the ES bring the account balance under $3,500 (the maintenance margin amount) the trader would have to deposit additional funds to bring the account value back to the required initial margin. The potential gains and losses of the position fluctuate every time the settlement price of the contract changes. The final gain or loss is determined when the position is closed or when the contract expires.
SEE: Buying On Margin and Maintenance Margin
A margin call occurs if the account falls below the maintenance margin amount. A margin call is a demand from the brokerage firm that money be added to a trading account to meet the initial margin requirements. If the demand is not met, the brokerage firm can close out any open positions in order to bring the account back up to the minimum value. The brokerage firm can close the position(s) without notifying the client in advance. Even if the brokerage firm offers the trader time to increase the equity in the account, it can sell off positions without consulting the trader. Traders may be able to avoid a margin call by closing out the losing position(s). Important terminology regarding margin are shown in Figure 3.
Figure 3 - Various margin terms.
Pattern Day Traders
Although futures traders are not subject to FINRA's Pattern Day Trading rule (which requires a minimum account size of $25,000), day traders may have different margin requirements than traditional overnight traders. If a broker-dealer identifies a client as a "pattern day trader" (anyone who executes four or more day trades within five business days), the broker-dealer may enforce special margin requirements on the client's day trading account(s).
Margin Trading Risks
Trading with margin involves a number of risks. The Financial Industry Regulatory Authority lists the followings risks of which traders and investors should be aware:
SEE: Margin Trading: The Risks
- A brokerage firm can force the sale of open positions to meet a margin call.
- The firm can close the positions with contacting the client.
- The client is not entitled to choose which positions are closed to cover a margin call.
- The firm can increase its "house" maintenance requirements at any time and without advance notice.
- Clients are not entitled to extensions on margin calls.
- Traders can lose more money than is deposited in a margin account.
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