Futures Margins

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Initial Margin

What Is Initial Margin?

Initial margin is the percentage of the purchase price of a security that must be covered by cash or collateral when using a margin account. The current initial margin requirement set by the Federal Reserve Board’s Regulation T is 50%. However, this regulation is only a minimum requirement, where equity brokerage firms may set their initial margin requirement higher than 50%.

Initial Margin

How Does Initial Margin Work?

To open a margin account at a brokerage firm, an account holder first needs to post a certain amount of cash, securities or other collateral, known as the initial margin requirement. A margin account encourages investors, traders, and other market participants to use leverage to purchase securities with a total value that’s greater than the available cash balance in the account. A margin account is essentially a line of credit in which interest is charged on the outstanding margin balance.

Key Takeaways

  • Initial margin is the percent of a purchase price that must be paid with cash when using a margin account.
  • Fed regulations currently require that initial margin is set at a minimum of 50% of a security’s purchase price. But exchanges can set initial margin requirements higher than the Fed minimum.
  • Initial margin requirements are different from maintenance margin requirements, which is the percent of equity that must be maintained going forward.

Securities in the margin account are paid for with cash loaned to the account holder by the brokerage firm and are designated as collateral. This process allows for magnification of potential profits but also magnifies potential losses. In the extreme event that securities purchased in a margin account decline to zero value, the account holder needs to deposit the full initial value of the securities in cash or other liquid collateral to cover the loss.

Special Considerations

For futures contracts, exchanges set initial margin requirements as low as 5% or 10% of the contract to be traded. For example, if a crude oil futures contract is quoted at $100,000, a futures account holder can enter a long position by posting only $5,000 initial margin, or 5% of the contract value. In other words, this initial margin requirement would give the account holder a 20x leverage factor.

During periods of high market volatility, futures exchanges may increase initial margin requirements to any level they deem appropriate, matching the power of equity brokerage firms to increase initial margin levels above those required by Fed regulation.

Initial Margin vs. Maintenance Margin

The initial margin requirement is the margin required when purchasing securities, which currently must be at least 50%. The maintenance margin is the amount of equity that must be maintained in the margin account going forward. The minimum maintenance margin requirement set by Reg T is 25%. That means an investor must maintain enough cash or collateral value in the account to cover 25% of the securities owned.

Maintenance margin helps ensure account holders maintain collateral in the account should the value of their securities fall. Some securities, especially volatile ones, will have higher margin requirements set by brokerages.

Example of Initial Margin

As an example, assume an account holder wants to purchase 1,000 shares of Facebook, Inc. which is quoted at $200 per share. The total cost for this transaction in a cash balance account would be $200,000. However, if the account holder opens a margin account and deposits the 50% initial margin requirement, or $100,000, the total purchasing power will rise to $200,000. In this case, the margin account has access to two-to-one leverage.

Learn About Futures Margin

Margin is a critical concept for people trading commodity futures and derivatives in all asset classes. Futures margin is a good-faith deposit or an amount of capital one needs to post or deposit to control a futures contract. Margins in the futures markets are not down payments like stock margins. Instead, they are performance bonds designed to ensure that traders can meet their financial obligations. 

Futures exchanges determine and set futures margin rates. At times, brokerage companies will add an extra premium to the minimum exchange margin rate to lower their risk exposure.   The margin is set based on the risk of market volatility. When market volatility or price variance moves higher in a futures market, the margin rates rise.   When trading stocks, there is a simpler margin arrangement than in the futures market. The equity market allows participants to trade using up to 50% margin.   Therefore, one can buy or sell up to $100,000 worth of stock for $50,000.

Margin Rate for Futures Contracts

In the world of futures contracts, the margin rate is much lower. In a typical futures contract, the margin rate varies between 3% and 12% of the total contract value.   For example, the buyer of a contract of wheat futures might only have to post $1,700 in margin.

Assuming a total contract of $32,500 ($6.50 x 5,000 bushels) the futures margin would amount to around 5% of the contract value. Initial Futures Margin is the amount of money that is required to open a buy or sell position on a futures contract.   Initial margin is original margin, the amount posted when the original trade takes place.

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Margin Maintenance

Margin Maintenance is the amount of money necessary when a loss on a futures position requires you to allocate more funds to return the margin to the initial or original margin level. 

For example, say the margin on a corn futures contract is $1,000 and the maintenance margin is $700. The purchase of a corn futures contract requires $1,000 in initial margin. If the price of corn drops 7 cents, or $350, an additional $350 in margin must be posted to bring the level back to the initial level.

Margin Calls are triggered when the value of an account drops below the maintenance level.   For example, say you hold five futures contracts that have an initial margin of $10,000 and a maintenance margin of $7,000. When the value of your account falls to $6,500 a margin call will require an additional $3,500 to return the account to the initial margin level. Closing or liquidating a position eliminates the margin call requirement.

Calculating Futures Margin

Exchanges calculate futures margin rates using a program called SPAN. This program measures many variables to arrive at a final number for initial and maintenance margin in each futures market. The most critical variable is the volatility in each futures market. The exchanges adjust their margin requirements based on market conditions. 

Margin in Futures Has Many Benefits

Margin is a good faith deposit that a market participant posts with the exchange clearinghouse. Think of margin as a down-payment on the full value of the contract that you are trading.   Margin allows the exchange to become the buyer for every seller and the seller for every buyer of a futures contract.

Two of the benefits of margin for market participants are; it guarantees anonymity (the exchange is always your counterparty), and it eliminates counterparty credit risk from the transaction.   Exchanges are regulated by the Commodities Futures Trading Commission (CFTC) and have plenty of funds on hand to meet all obligations. Those funds come from the margin collected by market participants.

Since margin is only a small percentage of the total futures contract value, there is a tremendous amount of leverage in futures markets. Look at an example:

  • Buy one contract of a COMEX gold future at 1270
  • Each contract is for 100 ounces of gold
  • Initial margin = $4400
  • Sell one contract of COMEX gold future at 1275
  • Profit: $5 per ounce or $500 per contract
  • If you bought the actual gold and made a $5 profit that would equate to a 0.3937% gain ($5/$1,270)
  • However, since you bought the gold futures contract, the gain is calculated on the amount of margin posted for the trade or $4,400 and the profit would equate to an 11.36% gain ($500/$4,400)
  • While the percentage gain in the futures market is high, remember that where there is the potential for rewards, there is always a risk. If you lost $5 per ounce on a one contract gold futures position, your loss would equate to 11.36% as well.

Exchanges set margin levels and constantly review them when market volatility changes; margins can go up or down at any time.   Futures Commission Merchants (FCMs) are permitted to require higher margins than exchange levels based on the risk of the customer and their ability to contact them on a moment’s notice. 

Margin is the glue that holds the futures markets together in that it allows market participates to trade with confidence that others will meet all obligations at all times.

What Is Maintenance Requirement Td Ameritrade

Pattern day trader is FINRA designation for a stock market trader who executes four or more day trades in five business days in a margin account, provided the number of day trades are more than six percent of the customer’s total trading activity for that same five-day period. “Pattern day trader” is a category subject to the Financial Industry Regulatory Authority (FINRA).

Maps, Directions, and Place Reviews

Basic summary

A FINRA (formerly National Association of Securities Dealers, Inc. or NASD) rule applies to any customer who buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period; the rule applies to margin accounts, but not to cash accounts. A pattern day trader is subject to special rules. The main rule is that in order to engage in pattern day trading you must maintain an equity balance of at least $25,000 in a margin account. The required minimum equity must be in the account prior to any daytrading activities. Three months must pass without a day trade for a person so classified to lose the restrictions imposed on them. Pursuant to NYSE 432, brokerage firms must maintain a daily record of required margin.

The minimum equity requirement in FINRA Rule 4210 was approved by the Securities and Exchange Commission (SEC) on February 27, 2001 by approving amendments to NASD Rule 2520.

Definition

A pattern day trader is generally defined in FINRA Rule 4210 (Margin Requirements) as any customer who executes four or more round-trip day trades within any five successive business days. FINRA Rule 4210 is substantially similar to New York Stock Exchange Rule 431. If, however, the number of day trades is less than or equal to 6% of the total number of trades that trader has made for that five business day period, the trader will not be considered a pattern day trader and will not be required to meet the criteria for a pattern day trader.

A non-pattern day trader (i.e. someone with only occasional day trades), can become designated a pattern day trader anytime if he meets the above criteria. If the brokerage firm knows, or reasonably believes a client who seeks to open or resume trading in an account will engage in pattern day trading, then the customer may immediately be deemed to be a pattern day trader without waiting five business days.

Round trip

Definition: The purchase and subsequent sale of forementioned purchased (stocks).

Day trading refers to buying and then selling or selling short and then buying back the same security on the same day. Interpretation for more complex situations may be subject to interpretation by an individual brokerage firm. For example, if you buy the same stock in three trades on the same day, and sell them all in one trade, that can be considered one day trade or three day trades. If you buy stock in one trade and sell the position in three trades, that is generally considered as one day trade if all trades are done on the same day. Three more day trades in the next four business days will subject your account to restrictions (you can only close existing positions or purchase with available cash up front) for 90 days, or until you deposit $25,000 into your account, whichever comes first. Day trading also applies to trading in option contracts. Forced sales of securities through a margin call count towards the day trading calculation.

Requirements and restrictions

Under the rules of NYSE and Financial Industry Regulatory Authority, a trader who is deemed to be exhibiting a pattern of day trading is subject to the “Pattern Day Trader” rules and restrictions and is treated differently than a trader that holds positions overnight. In order to day trade:

  • Day trading minimum equity: the account must maintain at least USD25,000 worth of equity.
  • Margin call to meet minimum equity: A day trading minimum equity call is issued when the pattern day trader account falls below $25,000. This minimum must be restored by means of cash deposit or other marginable equities.
    • Deadline to meet calls: Pattern day traders are allowed to deposit funds within five business days to meet the margin call
    • Non-withdrawal deposit requirement: This minimum equity or deposits of funds must remain in the account and cannot be withdrawn for at least two business days.
    • Cross guarantees are prohibited: Pattern day traders are prohibited from utilizing cross guarantees to meet day trading margin calls or to meet minimum equity requirements. Each day trading account is required to meet all margin requirements independently, using only the funds available in the account.
  • Restrictions on accounts with unmet day trading calls: if the day trading call is not met, the account’s day trading buying power will be restricted for 90 days or until day trading minimum equity [margin call is met].

Any legal restrictions on speculation permit to limit an activity that is negative with respect to moral-religious principles.

Day trading buying power

The rule provides day trading buying power to up to 4 times a pattern day trader’s maintenance margin excess. The excess maintenance margin is the difference of the account equity and the margin requirement. For example, if a trader has $100,000 worth of equities with no margin loan, the leverage ratio is 4:1, meaning that it can buy securities of up to $400,000. If the account has a margin loan, the day trading buying power is equal to four times the difference of the account equity and the current margin requirement.

For day trading in equity securities, the day trading margin requirement shall be 25% of either:

  1. the cost of all day trades made during the day; or
  2. the highest open position during the day.

If a client’s day trading margin requirement is to be calculated based on the latter method, the brokerage must maintain adequate time and tick records documenting the sequence in which each day trade is completed. Time and tick information provided by the customer is not acceptable.

Day trading in cash accounts

The Pattern Day Trading rule regulates the use of margin and is defined only for margin accounts. Cash accounts, by definition, do not borrow on margin, so day trading is subject to separate rules regarding Cash Accounts. Cash account holders may still engage in certain day trades, as long as the activity does not result in free riding, which is the sale of securities bought with unsettled funds. An instance of free-riding will cause a cash account to be restricted for 90 days to purchasing securities with cash up front. Under Regulation T, brokers must “freeze” an investor’s account for 90 days if he/she sells securities that have not been fully paid (i.e.,paid for with unavailable funds). During this 90-day period, the investor must fully pay for any purchase on the date of the trade.

History

Requirements for the entry of day trading orders by means of “pattern day trader” amendments: On February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to NASD Rule 2520 relating to margin requirements for day traders. The NASD amendments to Rule 2520 became effective on September 28, 2001, while the NYSE amendments to Rule 431, which are substantially similar, information memo from NYSE became effective August 27, 2001. Effective December 2, 2020, the NASD rule was revised, renumbered and incorporated into the FINRA Rule book. FINRA was formed by the merger of NASD Regulation and NYSE Regulation in July 2007. The SEC approved the formation of FINRA as a new SRO to be a successor to NASD Regulation and the enforcement and arbitration functions of the New York Stock Exchange. The Financial Industry Regulatory Authority is also known as FINRA.

Rationale

While all investments have some inherent level of risk, day trading is considered by the SEC to have significantly higher risk than buy and hold strategies. The Securities and Exchange Commission (SEC) approved amendments to self-regulatory organization rules to address the intra-day risks associated with customers conducting day trading. The rule amendments require that equity and maintenance margin be deposited and maintained in customer accounts that engage in a pattern of day trading in amounts sufficient to support the risks associated with such trading activities.

The SEC believes that people whose account equity is less than $25,000 may represent less-sophisticated traders, who may be less able to handle the losses that may be associated with day trades. This is along a similar line of reasoning that hedge fund investors typically must have a net worth in excess of $1 million. In other words, the SEC uses the account size of the trader as a measure of the sophistication of the trader. This rule essentially works to restrict less sophisticated traders from day trading by disabling the traders ability to continue to engage in day trading activities unless they have sufficient assets on deposit in the account.

One argument made by opponents of the rule is that the requirement is “governmental paternalism” and anti-competitive in a sense that it puts the government in the position of protecting investors/traders from themselves thus hindering the ideals of the free markets. Consequently, it is also seen to obstruct the efficiency of markets by unfairly forcing small retail investors to use bulge bracket firms to invest/trade on their behalf thereby protecting the commissions bulge bracket firms earn on their retail businesses.

On the other hand, some argue that it is problematic not because it is some sort of unfair over-regulatory attack on the “free market,” but because it is a rule that shuts out the vast majority of the American public from taking advantage of an excellent way to grow wealth. It does so by imposing a “poverty tax” on those who do not have $25,000 available.

Another argument made by opponents, is that the rule may, in some circumstances, increase a trader’s risk. For example, a trader may use 3 day trades, and then enter a fourth position to hold overnight. If unexpected news causes the security to rapidly decrease in price, the trader is presented with two choices. One choice would be to continue to hold the stock overnight, and risk a large loss of capital. The other choice would be to close the position, protecting his capital, and (perhaps inappropriately) fall under the day-trading rule, as this would now be a 4th day trade within the period. Of course, if the trader is aware of this well-known rule, he should not open the 4th position unless he or she intends to hold it overnight. However, even trades made within the three trade limit (the 4th being the one that would send the trader over the Pattern Day Trader threshold) are arguably going to involve higher risk, as the trader has an incentive to hold longer than he or she might if they were afforded the freedom to exit a position and reenter at a later time. In this sense, a strong argument can be made that the rule (inadvertently) increases the trader’s likelihood of incurring extra risk to make his trades “fit” within his or her allotted three-day trades per 5 days unless the investor has substantial capital.

The rule may also adversely affect position traders by preventing them from setting stops on the first day they enter positions. For example, a position trader may take four positions in four different stocks. To protect his capital, he may set stop orders on each position. Then if there is unexpected news that adversely affects the entire market, and all the stocks he has taken positions in rapidly decline in price, triggering the stop orders, the rule is triggered, as four day trades have occurred. Therefore, the trader must choose between not diversifying and entering no more than three new positions on any given day (limiting the diversification, which inherently increases their risk of losses) or choose to pass on setting stop orders to avoid the above scenario. Such a decision may also increase the risk to higher levels than it would be present if the four trade rule were not being imposed.

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