Investment Tools and Strategies: Trading on Margin
 
 
Investment Tools and Strategies: Trading on Margin

One attractive feature of trading futures is the availability of leverage. Leverage, in the financial sense, is the use of a relatively small amount of collateral (pledged assets) in order to control a proportionally large amount of a security - in this case a futures contract. One way to achieve leverage when trading is to use a margin account.

Margin Account

In order to leverage your trading capacity, you open a margin account. The margin is "the amount of equity contributed by a customer as a percentage of the current market value of the securities held in a margin account." Equity can be in the form of cash or by pledging other securities, such as bonds. Margin requirements are minimum levels that must be met. These limits are set by exchanges – and managed by brokers – in order to reduce credit risk (the computed value of a trader not fulfilling his obligations). Margins are required from both your futures commission merchant and you, and vary between exchanges.

There are several margin requirements involved with futures trading (see Figure 6-1). Often a trader can borrow up to 50% of the contract purchase price; this is where leverage takes place. For example, you can open a $10,000 position on Live Cattle contracts by using $5,000 in your margin account. Novice traders are cautioned not to expose themselves completely by using the full margin amount. Because of margin restrictions, a trader may be called by her broker to deposit more collateral in order to maintain an open position. This margin call requires immediate response, either by depositing cash or other securities or by closing the position.
Margins – sometimes called performance bonds – average between 2% and 15% of the open position. The maintenance margin is typically lower than the initial margin, and you can continue to employ a margin throughout the life of your open position, but when the position is closed, the cost of using the margin is deducted from the proceeds of the trade first. On many exchanges, initial margin amounts are different for speculators compared to hedge funds or commodity producers and dealers. For example, the Chicago Mercantile Exchange requires a $2,025 initial margin on Corn contracts for speculators versus $1,500 for hedge funds.

When a position is closed the broker receives the proceeds and deducts the cost of providing the margin to the account holder. The amount deducted is based upon the margin rate the broker charges. The margin rate is the interest rate applied to your account while margin trades are in effect. If the trade results in a loss, the margin cost must still be paid from the proceeds. Because futures exchanges require open positions to be marked to the account daily, account holders must constantly be aware of the margin requirements. Keep in mind that if equity falls below margin levels, you will receive a margin call.

Margin Call Explained
There are primarily two times when a trader may receive a margin call. First, when the value of a trader's open positions drops below the maintenance margin, the broker will call the trader and demand a deposit or a position must be closed. Second, when a trader wishes to open a new position and the maintenance margin is exhausted the broker will request more equity. Calls for meeting margin requirements are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed out the client is liable for any resulting deficit in his account. Calls can be made daily or even intraday during times of fast-moving price swings (called volatility).

An example of a margin call:

  • Trader buys $10,000 in Treasury Bill contracts using a $5,000 initial margin (50% equity, 50% margin)
  • Contracts' value drops to $6,000 (result = Equity/$1,000 Margin/$5,000)
    Want to learn more? Take an online course in Investing.
  • Broker's maintenance margin is 30% (30% of $6,000 = $1,800)
  • Margin call for $800 would be required ($800 + $1,000 = $1,800)

In this example, the account holder must deposit $800 cash, sell other securities that return $800 or close enough of the open position to increase the equity to $1,800. Keep in mind that, any security sales will result in the margin rate also being deducted. It is important to note that the broker has the right to liquidate (close) your position without consulting you, even if you ignore the margin call.

There is a distinction between an initial margin call and a maintenance margin call. Securities such as warehouse receipts or government-issued assets can be pledged for initial margin requirements, whereas maintenance margin calls must be met with either cash deposits or exiting the position. Maintenance margins are based upon market action and therefore require immediate cash transactions in order to return the account to adequate equity levels.

Margin vs. Cash Trading
As stated earlier, the use of leverage can increase the gains you'll realize but also the losses you can suffer. Figure 6-2 shows the difference between using a cash account versus a margin account. Leverage is applied through the margin account because adjustments to the account's value are made only to the equity side. Therefore, when the futures' value moves up, your equity position can see sharp rises, but when the value moves down, your debt obligation to the broker can make the loss increase substantially. When adjustments are made, they hit the equity portion of the account – your cash holdings – first in either direction.

So you see, in the case of a gain, you would realize a profit of 40% in a cash account and 72% in a margin account. In the loss scenario, the cash account would lose 40% of its value versus an 88% loss through a margin account. The use of leverage through a margin account is very risky, therefore many traders are encouraged to trade a cash account unless they can easily absorb the risks.
Options

Options are another form of leverage, which involve additional risks and rewards. An option is a contractual agreement that gives the option buyer the right, but not the obligation, to purchase or sell a futures contract. It can provide protection against a price decline on a commodity or a bet on the movement of a market index or similar investment.


Options are used by hedgers as an "insurance" policy on their assets, as well as by speculators who wish to commit a smaller amount of money towards their expectations. The seller (otherwise known as the writer) extends the offer to the buyer (called the holder) in exchange for a premium – the price of the option. The difference between the two sides is that the holder is not obligated to fulfill his commitment on the contract, but the writer must make good on the obligation if the holder chooses to exercise his right.

Options Explained
Options are traded as a separate investment vehicle on the exchange. Participants in options markets are not obligated to deliver or receive a commodity by simply holding the option contract; instead it is the futures contract that is the underlying asset. Each option contract covers the equivalent amount of asset (commodity, financial, index, etc.) as the underlying contract. For example, an option on a single CBOT Corn contract gives the holder the right to buy or sell a 5,000 bushel futures contract. The option contract lists the size, expiration date, specified price and underlying futures contract that is covered.

The holder of the option can close his option interest in two ways: 1) exercise the option by purchasing or selling the underlying contract to the writer or 2) offset his position by selling a long position or buying a short position on the same option contract. In the US, the holder can exercise his right at any time prior to the option's expiration date. Options can be exercised by either physical delivery of the futures contract or by cash settlement, in which the value of the underlying contract is credited to the account holder minus the original specified futures contract price.

Options have an expiration date similar to a futures delivery date. The expiration date falls in the same month as delivery for most option contracts, usually two to three weeks prior to delivery. If you choose to let the option expire – making it worthless – you lose only the premium amount paid. Assignment (the fulfillment of the obligations of the counterparties) and clearing for options contracts occur through the Options Clearing Corporation (OCC), an exchange member that acts as a guarantor of options transactions. There are two types of options:
  • PUTS –A put gives the holder the right to sell a contract at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.
  • CALLS – A call gives the holder the right to buy a contract at a certain price within a specific period of time. Put another way, calls offer the ability to establish a long position on a contract. Buyers of calls hope the contract price rises before the option expires.
Option Pricing
Options are priced separately from the futures contract price. When trading futures options, there are two price points that are involved: the premium price for the option and the strike price of the futures contract. The strike price is the price at which the underlying contract must be sold to the option holder. Although the premium on an option contract may fluctuate due to market sentiment, the strike price remains constant. If the price for the futures contract rises or falls significantly, there are usually new options offered at different strike prices.

Example: On the CBOT, the March Oats futures contract trades at $2.00 per bushel. There are March call options with strike prices of $1.95, $2.00, $2.15 and $2.18. The option pricing looks like this:

$1.95 strike price = $.30/bu

$2.00 strike price = $.10/bu

$2.15 strike price = $.05/bu

$2.18 strike price = $.02/bu

This means that it will cost the option holder $.30/bu ($1,500) to buy the March 1.95 strike call option. If she chooses to exercise the option, the actual cost per bushel will be $2.25/bu.

When the current (spot) price for the underlying contract is lower than the strike price of a put option or higher than a call option, the option has intrinsic value. The premium for the option rises and falls (just like the underlying contract) based upon factors such as the intrinsic value, market volatility and the time until expiration (called the time value). Option premiums tend to decline as the expiration date draws nearer.

Options traders use three terms to describe how a strike price relates to the spot price (see figure 9-1). In-the-money options typically have the highest premium; strike prices that are out-of-the-money are the least expensive; and at-the-money premiums trade somewhere in between.

The risk level for buying an option changes as the spot price moves, and that level is reflected in the premium. Risk is greater as the option moves more out-of-the-money and lesser as it becomes more in-the-money. There are complicated formulas that professional traders use to determine the timing of entering and exiting an options position that reach far beyond the scope of this article.
How Options Leverage Works
Options on futures contracts are considered more risky (and rewarding) than trading futures contracts because of the increased use of leverage. An option requires less financial commitment than entering a futures position, but essentially controls the same sized asset. Using the above example, let's look at how leverage works in trading options:

March Oats at $2.00/bu ($10,000/contract) and March $2.00 strike call option at $.10 ($500/ contract). With $10,000 a trader can purchase one March futures contract or 20 call options. With the same amount of money, you can control 20 times more bushels buying the option.

Leverage expands a trader's gains and losses because small movements in the underlying contract are multiplied by the number of units you are controlling. The downside is that, as the option expiration gets closer, the risk of loss becomes greater because the time value decreases rapidly, which puts the initial investment completely at risk. In addition, option prices usually don't move equally in relation to the futures contract, thus requiring greater relative movement in the futures contract in order to realize a gain on the option contracts.

Buying vs. Selling Options
The benefit to purchasing options is that there is a smaller financial commitment versus establishing a position in a futures contract, but the cost of exercising the option includes the premium paid as well as the actual futures contract price. If you are write an option position the downside risk can be substantial because the holder can force assignment if the spot price is significantly more advantageous than the strike price, requiring you to sell the futures contract. Figure 9-2 explains the various positions.

Traders employ an option basis – a formula that calculates the value difference between a put and a call – to determine the appropriate spot and strike prices to enter or exit a position. This includes the commission costs, capital gains taxes, etc. Another formula, called the delta, indicates how the option price will move relative to the futures price. Call options have a delta between 0 and 1 and put options have a delta between 0 and -1. If an option has a delta of 1 or -1, that means the option price moves $1.00 for every $1.00 movement in the underlying contract. For example, the price of a May Wheat call option with a delta of 0.50 will increase $.50 for every $1.00 rise in the contract price.
Options Management
Managing your options is critical to successful speculating. Knowing when to exercise, offset or allow the option to expire will determine the return on the investment. According to the Chicago Board Options Exchange (CBOE) options positions are exited in three ways:
 
 
Popular Courses
 
Learn More! Take an Online Course...