If you’re new to futures, then you may find yourself asking: What is margin trading? In short, margin trading is the act of securing the rights to an asset via third-party financing. However, its functions and applications in the futures markets go much deeper than simply taking out a loan.
Margin Trading 101
Margin trading is the borrowing of money by a trader ― from a broker ― for the purchase or sale of a security. Margin refers to the up-front capital put forth by the trader and acts as a good-faith deposit on the extended credit. Margin requirements are devices used to govern the transaction and may vary according to brokerage, as well as by the market being traded.
Although the essential definition of margin trading is the same from market to market, its applications in futures are unique. To fully answer the question of what is margin trading in futures, it’s necessary to take into account these considerations:
- Derivative products: Futures contracts are derivatives products, meaning that their value is dependent upon the value of an underlying asset. In addition, the products themselves are leveraged, thus traders are able to control large quantities of said assets with minimal capital. This runs contradictory to stocks or mutual funds, where the security’s market price is its acquisition cost and de facto value.
- Types of margin: In futures, several types of margin are used to facilitate trade. Intraday margins represent the capital needed to hold positions from the opening to closing bell. Overnight margins define how much money is needed to hold open positions through the electronic close. For futures, determining exactly what is margin trading varies depending upon the situation and strategic objectives involved.
- Enhanced purchasing power: Relatively speaking, the margin requirements in futures are low. In comparison to the 50% of a stock’s face value demanded by the U.S. Securities and Exchange Commission (SEC), futures contracts call for between 3% and 12%. Purchasing power is clearly boosted dramatically in futures.
So, what is margin trading in futures? Simply put, futures margin trading is the use of credit extended by a broker for the buying or selling of contracts. It offers increased purchasing power and flexibility over that available in the traditional equities markets.
The Role of Margin in Futures Trading
While the definition of margin is fairly straightforward, its role in active futures trading is nuanced. It’s important to keep in mind that without the purchasing power provided to traders via margin, the futures markets would be beyond the reach of most retail participants.
If you’re going to trade futures, then knowing how margin can impact day-to-day operations is essential. Here are two important things to keep in mind before jumping into the market with both feet:
- Respect margin: Margin requirements put forth by the exchange and brokerage service are best respected. When they’re violated, position liquidations, margin calls, and added fees may be implemented by or on the broker’s behalf.
- Margins exist for a reason: Although they’re often viewed in a negative context, margins are a positive device. Not only do they promote market liquidity, but they also can prevent the trader from becoming overextended. While margins may be perceived as a liability, they serve as a form of protection for all parties involved.
Before ever risking a dime of your hard-earned money in the live market, you should be able to answer the question of what is margin trading in detailed terms. In doing so, you will be better equipped to avoid unfortunate events, such as premature position liquidations, margin calls, and devastating capital losses.
Getting Started with Futures
When it comes to margin, it pays to be in the know. If you’re a bit confused about the general topic, talking with a futures industry professional can help. For more information on the ins and outs of futures margin trading, contact a member of the Daniels Trading team today.