Funding a Futures Account
Futures are not bought or sold. Like forward contracts, they are only promises to buy or to deliver a commodity, or other asset, at a specified price during the specified delivery period or settlement period. Even if the futures trader has no intention of delivering or taking delivery of the underlying asset, he, nonetheless, accepts an obligation to do so until he closes out the position by offsetting the contract—buying a contract that he sold short, or selling a contract that he bought long. Often, the money in a futures account is referred to as margin, but the margin required for a futures contract is not like the margin used to purchase stocks. It is not borrowed money and no interest is paid for it. Its purpose is to insure contract performance and to protect the financial integrity of the futures markets. It is, therefore, often called a performance bond.
Margin can be in the form of cash, U.S. treasuries, letters of credit, or negotiable warehouse receipts, and is required of both buyer and seller.
Margin requirements typically can range from 5% to 20% of the contract price, depending on the volatility of the underlying asset and whether the account is used for speculating or hedging, as specified in the application to open the account. The low margin requirements yields a large capital leverage, and gives futures a much greater volatility than the price of the underlying asset.
Example—Margin Requirements for Butter Futures at the Chicago Mercantile Exchange
Each type of futures contract has its own minimum levels of original margin, determined by the exchange. The clearinghouse may increase the margin requirement further, and the FCM (broker) may require a higher level, but cannot allow a lower one.
A maintenance margin (or maintenance performance bond), set by the exchanges, must be maintained daily as the settlement price changes. If the margin level drops below the requirement, typically 75% of the original margin, either more cash or securities must be deposited, or futures contracts must be offset to raise the margin level back to the required level.
The commodity futures broker (who can be a futures commission merchant (FCM) or an associated person of an FCM or an introducing broker) issues the margin call (or performance bond call) and follows up to insure that more cash or securities have been received. If not, then the broker may close out the contracts requiring the additional margin; close out any other futures positions in the account; or transfer the funds from another account that was specified in the agreement when the futures account was opened.
The margin remains with the FCM in a segregated account. The FCM, being a clearing member, must also post margin in its open accounts with the clearinghouse. However, all the accounts, both long and short, are aggregated as a whole, and, thus, the FCM only needs to deposit the amount of margin necessary to maintain the margin level as a whole.
The exchanges can increase margin level requirements to lessen volatility. Increasing the margin effectively increases the prices of futures, thus lowering demand, which lowers volatility. Lowering the margin requirements has the opposite effect.
Mark to Market
When you buy or sell a futures contract, you must deposit, or have sufficient margin to cover the original margin requirements. When the FCM clears the transaction with the clearinghouse, the FCM must either have, or deposit, sufficient margin to cover the transaction with the clearinghouse.
Because futures contracts are highly leveraged, margin levels are calculated daily, to protect the financial integrity of the clearinghouse. At the end of each trading day, the clearinghouse marks to market each open futures account with the last trading price, called the settlement price. In other words, the new futures price is used in calculating whether there is sufficient margin in the account to cover the new settlement price. If, after marking to market, the account's margin has dropped below the maintenance level, then a margin call will be issued, and must be deposited before the next opening of trading. This is called variation margin.
In certain emergency conditions, such as with stock index futures during the stock market crash in 1987, the exchange may require variation margin during the trading day, that must be delivered to the clearinghouse within 1 hour.
Daily Price Change Limitations
Each commodity may have a daily price limit, set by the exchange, to limit volatility due to news or other factors. For instance, the price limit for butter futures on the Chicago Mercantile Exchange is 5¢ per pound. That means that the price of butter cannot increase more or decrease less than 5¢ per pound per day, or $2,000 per contract, since each contract is for 40,000 pounds of butter.
However, if the daily price changes keep reaching the limit on successive days, then the daily limit may be expanded to accommodate market forces. If the daily price variation diminishes, then the old price limits may be re-established. Because prices can, and often do, change substantially during the spot month—the month of delivery—there may be no daily limits during this time.
Example—FCOJ-A Futures on the New York Board of Trade (NYBOT)
Generally, NYBOT—which has such diverse products as cocoa, coffee, cotton, the U.S. Dollar Index, and the FINEX Euro Currency Index (ECX)—doesn't have daily price limits for most of its futures, but orange juice solids are an exception, along with cotton and the Russell Complex and the NYSE Composite indexes. Below is the contract specification for the limits on the daily price movements for orange juice solids. Contract size is 15,000 pounds of orange juice solids, and the minimum price tick is .05¢ per pound, or $7.50 per contract.
Daily Price Limit
"Daily Limit: First and Second Listed Futures Months: a movable 10 cents above or below the previous day's settlement price. All Other Months: 5 cents above or below the previous day's settlement price; when 3 or more months close at the limit in the same direction for 3 successive days, the daily limit expands to 8 cents. When prices are locked at the limit at the end of a trading day in any month, imputed settlement values may be used for margin calculation purposes."
Example—Maximum Daily Price Fluctuation for Light, Sweet Crude Oil at the New York Mercantile Exchange (NYMEX)
"$10.00 per barrel ($10,000 per contract) for all months. If any contract is traded, bid, or offered at the limit for five minutes, trading is halted for five minutes. When trading resumes, the limit is expanded by $10.00 per barrel in either direction. If another halt were triggered, the market would continue to be expanded by $10.00 per barrel in either direction after each successive five-minute trading halt. There will be no maximum price fluctuation limits during any one trading session."
The FCM, acting as a broker for futures contracts, charges commissions for each trade. Commissions vary widely among FCM's. As with brokerages for stocks, there are full service FCM's and discount FCM's, the latter providing little service for their lower commission schedule.
The highest commissions are for long or short positions held longer than 1 day. Commissions are less for a spread, when bought or sold as a spread, and they are also lower for trades that are closed out in the same trading session they were opened.