Trading on Margin

Suppose you've been reading the newspaper lately and seen the substantial rise in inflation over the last two years. You bet, along with many others, that this trend is likely to continue for the next two years. You decide to hedge your portfolio, and possibly pick up some profits, by investing in gold.

Unfortunately, you don't have $58,000 to purchase 100 Troy ounces of gold at the current market price of $580. Instead you do what most speculators do, you buy a gold futures contract. Now instead of having to come up with $58,000 you only have to invest an initial amount of $2,900, 5% of the total.

That 5% is known as the (initial) margin. The exact percentages are set by the exchanges and brokerage firms on a daily basis, per individual commodities futures contracts. Exchanges monitor prices, volatility and many other factors to determine acceptable levels of risk and then set the margins accordingly. Minimums are set by the exchange, but brokerages will sometimes have slightly higher requirements.

Now suppose the price of gold rises by $5 before the expiration of the contract. Excellent. You've made $5 per ounce x 100 ounces = $500 (excluding commissions, around $20). If you had purchased the gold outright you would have made the exact same amount of profit. But look at the difference between outright purchase and a futures contract in percentage terms.

$500/$58000 x 100% = 0.86%, slightly less than 1%. On the other hand, $500/$2900 x 100% = 17.2%. That difference is the effect of something known as leverage. You invested only 5% of the total purchase price, but you still get 100% (ignoring commission) of the profits, not 5% of the profits.

But with the possibilty of reward comes the risk of loss. If the price had decreased $5 and never rose again before the contract expired, the result would have been a $500 loss instead. In order to protect themselves against the possibility that you won't be able to cover the amount at expiration, brokers may issue something known as a 'margin call'.

All potential profits and losses are calculated and settled on a daily basis. If the price drops below the minimum set by the broker (based on the exchange minimum), brokers will require their clients to deposit additional funds to bring the account back up to the level of the initial amount.

Here's the kicker. They may or may not give you adequate notice and time to actually do that. Depending on the level of price volatility, the amount involved, and your relationship with them, brokers can (and sometimes do) liquidate your position without waiting for you.

Under normal circumstances, most brokers will give you notice and reasonable time to meet this 'maintenance margin', the amount required to bring your account up to the required level. But it's the trader's responsibility to monitor his or her positions and know the guidelines.

Beyond bringing the account up to the previous level, it's possible you may have to come up with an even larger amount. Exchanges and/or brokers can and do raise (or lower) the minimums depending on current market conditions.

Futures trading, particularly in the fast-paced, high risk world of commodities, isn't for everyone. A high tolerance for risk and the ability to input additional funds is necessary, along with the ability to withstand the losses.