Futures
contracts are highly
leveraged
instruments. Leverage
is the ability to control large
dollar amounts of a commodity
with a comparatively small amount
of capital. In most cases, you
can buy or sell futures with a good
faith deposit,
or initial
margin
of
10% or less of the value of the
contract on delivery. The
margin acts as a performance bond that
is available to the futures broker
to meet your obligations for potential
losses on a futures position.
Changing contract value
Both over the term of your futures contract and throughout a regular trading day, the price of liquidating your futures position changes constantly. So during the term of a contract, you must maintain the margin level of your account, adding money if required to cover the loss if the value of the contract you hold drops. Maintenance margin requirements may differ from initial margin requirements, depending on the exchange. Maintaining an appropriate margin level affirms to the exchange that you will meet the terms of the contract, either by delivering or taking delivery of the underlying commodity, or, as happens in an estimated 98% of futures transactions, by buying or selling an offsetting contract.
The changes in contract value are caused by fluctuations in the price of an offsetting contract, which in turn is caused by changes in the cash price of the underlying commodity, among other factors. The difference between the price of your contract and the price of an offsetting contract represents the profit or loss of the position.
Using margin to control market volatility
Initial and maintenance margin levels are generally set by the futures exchange, although a clearinghouse or a broker may require higher margin levels. Margin helps control the risk to which traders are exposed. If market prices start to move rapidly and the market becomes more volatile, margin rates can increase. This helps to ensure that traders don't expose themselves to risks that exceed the capital in their account. That is, higher margin requirements can slow trading, as traders will be able to take fewer positions with the same amount of money.
