Futures For You - October 2007

Futures For You

INSIDE THE FUTURES WORLD
Want to learn how the futures markets really work? Dan O'Neil, a principal at online futures and forex broker Xpresstrade (www.xpresstrade.com), responds to your questions about today's futures markets.

To submit a question, post your question to our website at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.

Dan O'Neil

MARGIN FOR ERROR
After years of trading stocks exclusively, I've recently started trading futures. Unfortunately, I also just received my first margin call. While I was able to get through it without too much difficulty this time, it made me realize I probably didn't do enough homework on how margin works on the futures side. Can you break down some of the differences between margin in the stock market and margin in futures?
A margin call is indeed a harsh welcome to the world of futures trading. But after surviving one, the important thing is to learn more about how margin works in order to avoid another. Understanding the several different kinds of margin involved in futures trading is as essential to succeeding in these markets as anything else you could possibly learn. Having had previous investment experience in the stock market, your knowledge of margin was likely limited to the cash down payment and money borrowed from a broker to purchase stocks. But in futures trading, margin has an altogether different meaning and serves a completely different purpose.
Instead of acting as a down payment, the margin needed to buy or sell a futures contract is solely a deposit of good faith money that can be drawn on by your brokerage firm to cover losses you may incur in trading. The exchanges are responsible for setting minimum margin requirements for individual futures contracts, and they continuously monitor market conditions and risks to determine whether to raise or reduce these requirements. Exchange margins are typically about 5% of the current value of the contract, but individual brokerage firms may require higher margin amounts than these exchange-set minimums from their customers.
In the futures markets, the two margin-related terms you need to know are initial margin and maintenance margin. Initial margin is the sum of money you must deposit with your brokerage firm for each futures contract to be bought or sold. Profits on your open positions are added to the balance in your margin account, while losses are deducted. If and when the remaining available funds in your margin account are reduced by losses to below a certain level -- known as the maintenance margin requirement -- your broker will require you to deposit additional funds to bring the account back to the initial margin level. A decision by the exchange or your brokerage firm to raise margin requirements can also trigger a request for additional funds. These requests, as you know, are known as margin calls.
Assume, for example, that the initial margin needed to buy or sell a particular futures contract is $2,000 and that the maintenance margin requirement is $1,500. If losses on open positions reduce the funds remaining in your trading account to $1,200 (less than the maintenance requirement), you will receive a margin call for the $800 needed to restore your account to $2,000. As you can see from this example, should your account go on margin call, exchange rules require you to bring your equity all the way back up to the initial margin level.
Given the possibility of margin calls, it is important to understand your brokerage firm's margin agreement and know how and when the firm expects margin calls to be met. Some firms may require only that you mail a personal check, while others may insist you wire funds from your bank or provide next-day delivery of a cashier's check. If margin calls are not met in the prescribed time and form, the firm can protect itself by liquidating your open positions at the available market price, so it's very important to stay on top of margin at all times.
In a perfect world, a futures trader will never have to confront a margin call. But if it does happen, the best you can do is know why it occurred and what can be done to prevent it from happening again.

SPREADING THE LOVE
What are some of the most common ways to use spreads when trading futures?
Most people think of speculative futures transactions as either a simple purchase of futures contracts to profit from an expected price increase or, conversely, a straight sale to profit from an expected price decrease. In reality, however, a number of other possible trading strategies exist, including spreads. In its simplest form, a spread involves buying one futures contract and selling another, with the hope of profiting from an expected change in the relationship between the purchase price of one and the selling price of the other.
Futures spreads generally fall into one of two categories. An intramarket spread is a time spread that involves taking a long position in one contract month against a short position in another contract month in the same futures contract on the same exchange. Intramarket spreads attempt to capitalize on the price differences between various futures delivery months within the same commodity. An intermarket spread, on the other hand, consists of a long position in one market and a short position in another market trading the same or a closely related commodity. Some popular intermarket spreads involve currency products like the euro and yen, or agricultural commodities like corn and soybeans.

Originally published in the October 2007 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.
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