| How Margin Trading Works |
| Written by Aaron Adam | |
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Margin buying is essentially the purchase of securities with money borrowed from a broker. You put up a certain amount of cash and the broker gives you more money. Other securities owned by the buyer are used as collateral. Margin buying has the effect of allowing investors to make big futures purchases with a small amount of money, but if their investment goes south the potential for loss can be devastating. In margin buying, the net value of the securities must stay at a level above a minimum margin requirement. This means the securities you put up as collateral must remain worth more than a specified minimum in order to protect the broker you're borrowing money from against a dip in the value of the securities that would leave you unable to cover the loan. Margin buying got its start in the stock market, but the financial innovation was eventually phased into the futures trading market. There are two main selling points for margin trading with regard to futures trading. Advantages of margin trading in futuresOne, the margin requirements for futures trading is relatively low compared to that in the stock market. Usually in the stock market you can only borrow about four times the amount of of cash. In futures trading, the margin requirements can be as little as one percent of the position value. This has the effect of greatly magnifying gains, while also exponentially increasing your chance of loss. In short, it's a big gamble.Second, in futures trading you are not required to pay for the use of margin as stock trading requires. Although you only have to put down some of the trading value when you're engaged in margin trading in the stock market, ultimately, the full position value must be put up by your broker to place the trade. Because of this requirement, stock traders are required to borrow the remaining trade value from the broker, thus incurring interest because this is a loan. The futures market differs because margin there is viewed as a "performance" bond. In layman's terms, a performance bond is money you need to have to cover losses on borrowed money incurred on a trade. Because the futures market doesn't require you to have the amount of the full position to make a trade, there's no interest paid when you trade on margin in the futures market. How margin trading is different in the futures marketThere are also some other key points you should understand with regard to the use of margin in the futures market. In the stock market, margin requirements are pretty much the same no matter what stock is being traded. In the futures market, margin requirements can widely differ depending on what type of futures contract you are trading. In futures contracts, margin requirements are established depending on the position size of the contract and the volatility of the underlying asset. The wider the price swings, the higher the margin requirement will be.A key similarity between trading on margin in the stock market and futures markets is the initial and maintenance margin requirements for futures contracts. This means you need to have a set amount of cash in your margin account to open a new position, and you must also maintain a certain amount of money to hold the position after you've opened it. Overnight and daytrading margins in the futures markets can also vary. Overnight initial and maintenance levels tend to be higher than daytrading margins because of the increased risk. Finally, it's important to keep in mind that brokers or markets can change their margin requirements at any time because of increased volatility in the futures market. If the maintenance requirements are increased, futures traders will need to pump more money into their account to meet the new margin requirements. Margin trading can significantly increase your potential for gain in the futures markets, but it does carry some increased risks. To minimize these risks, futures traders should thoroughly research margin trading, their own financial position and the underlying commodity they wish to trade before buying on margin. |
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