Margin

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Margin has a different meaning depending on the particular financial industry being discussed. In some cases, it is a partial payment for stock, and in other cases it is a good-faith deposit, or performance bond, to assure that potential market losses are covered. The futures exchanges frequently have used the term "performance bonds" instead of "margin" to avoid confusion. The typical stock trader looks at margin very differently from the futures trader, who is used to different conventions; they are entirely different concepts. For the sake of this topic, however, we will use the words "margins" and "performance bonds" interchangeably when it comes to futures.

Futures Margin/Performance Bond

When a customer trades futures, he or she must post an initial performance bond known as margin with a futures broker, which in turn is held at the exchange’s clearing house. A performance bond is simply a good-faith deposit to assure that there is enough cash or other acceptable collateral in the customer's account to cover any losses that could result from ensuing market transactions.

Minimum performance bonds are based on a percentage of a contract’s underlying (notional) value, and minimums are determined by the exchange on which the product is listed. Futures margins are usually a relatively small fraction of the total value of the position being traded, typically between about 5 and 15%. The amount required for a performance bond also is affected by the volatility of the product being traded; generally, the more volatility, the larger the performance bond becomes. This ensures that the performance bond will cover the maximum losses that a contract could incur in a single day.

Additionally, a brokerage firm (Futures Commission Merchant) has the right to increase the amount of a performance bond from exchange minimums. The firm, however, cannot specify a performance bond that is lower than exchange minimums. 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.

Performance bonds protect both the trader and the integrity of the industry because trading losses are not allowed to accumulate from day to day. If performance bonds were not monitored on a daily basis (and sometimes, in very volatile markets, intra-day), losses could easily mount, putting the trader in harm's way over a period of days.

One of the reasons performance bonds are so important is because leverage in futures is high. In other words, the amount of money a trader commits relative to the actual underlying value of the contract is quite low, as mentioned earlier between 5 and 15% of the actual value of the contract. But because futures are leveraged, the effect of price changes is likewise magnified. A trader can lose more than the amount of money he or she has deposited for a futures position.

Margin for futures contract is often calculated as two amounts. The initial margin is the amount required per contract to enter the trade and establish the position in the market. Should the position be held past the entry day's market close, a lower maintenance margin is used to identify the minimum amount per contract required to hold the position.

At the end of each trading day, the exchange establishes the settlement price for each contract, and the account is credited or debited based on gains or losses in open positions, based on that settlement price. This is known as marking to the market. As part of the daily account calculations, each day's updated account value is compared to the maintenance margin required to support the account's open positions.

Futures customers with accounts that drop below the amount of margin required must add money to bring the account back up to the minimum margin; the process of notifying a trader of the need for additional margin is known as a margin call. Normally, the trader is given only a brief period (often a single business day) to provide additional funds. If the trader does not supply the required margin in time, positions within the account may be liquidated to protect against additional losses; and in some cases, the account may be closed.

Stock Margin

In the stock arena, buying "on margin" is borrowing money from a broker to purchase stock, in essence, a loan from the brokerage firm. Margin trading allows investors to buy more stock than they would be able to normally.

To trade on margin, an investor needs to establish a margin account with a broker-dealer. This differs from a regular cash account that the investor uses for trading/investing. Once the account is operational, most but not all investors can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that investors deposit is known as the initial margin. Investors are not required, of course, to margin all the way up to the 50% and can certainly borrow less. Additionally, some brokerage firms require investors to deposit more than 50% of the purchase price.

Generally, investors can keep the loan as long as they wish as long as they fulfill their obligations. When an investor sells the stock in a margin account, the proceeds go to the broker against the repayment of the loan until it is fully paid. There is also a maintenance margin, the minimum account balance the investor must maintain before the broker will force him or her to deposit more funds or sell stock to pay down the loan. When this happens, it's known as a margin call.

Not incidentally, the ability to borrow on margin has a cost. Marginable securities in the account are collateral, but there is interest on the loan, which is applied to the account unless the investor makes interest payments along the line. Over time, the debt level increases as interest charges accrue against the account holder.

In equities, buying on margin may be more appropriate for shorter-term investments. The longer one holds an investment, the greater the return needed to break even.

Not all stocks can be bought on margin. The Federal Reserve Board regulates which stocks are marginable. Generally, 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 potential risks. Brokerage firms, individually, can also decide not to margin certain stocks.

Options Margin

Security options margins are based on the particular options strategy being employed rather than on the underlying value of the security option or index option. A riskier strategy, e.g., selling a put, would, for example, be considered riskier than buying a put option to protect an underlying stock from a decline in price.

Margin for options on futures contracts are defined by the type of position rather than by the direction of trade. Buying options does not require margin, since the purchase action transfers the entire option price from buyer to seller. Selling an option, however, can produce similar risk to taking a contract position in the market; because of this, margin is required for each option that is sold. Usually, margin for selling options is equal to the margin required for taking contract positions; in some cases, some or all of the premium received by the option seller may also be quarantined and made unavailable for other uses while the position is open.

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