The futures market (part 4)

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The Futures market (part4)

In the last editorial I described the main features of a futures market.  First thing first.  Futures are exchanged traded contracts.  They are standardised, so all participants know exactly the size of the contract, the delivery date, and all the information that make up the contract. 

So how much it cost to trade futures contract? Ok, First we need to remember that when we agree to buy a futures contract we call it a long position and when we agree to sell a contract we call it a short position. The full price of the contract does not need to be paid up front.   Instead, they are only required to pay a deposit or initial margin. The initial margin will be set at a minimum percentage of the value of the futures contract.  This will usually range between 2 to 10%.

The initial margin is held by the clearing house.  Initial margins change from time to time, depending on the price volatility of the price of the commodity or financial instrument underlying the futures contract.  During periods of high volatility, the percentage margin may be increased.  The initial margin is similar to a performance bond or collateral that supports the value of the futures contract.  The initial margin is imposed to ensure that brokers and their clients are able to pay for any losses incurred during the life of the contract.

The margin system was developed by the Chicago Mercantile Exchange (used also in Australia).  It is known as SPAN (standard Portfolio Analysis of Risk).  This system uses a set of predetermined parameters that are set by the clearing house in order to assess the maximum potential loss that can be expected on a specified portfolio over a one day period.

Now the buyer and the seller cannot make money at the same time. The movement of the price of the instrument will turn into profit for one but will be detrimental for the other.  The risk is covered by the margin. The adverse movement must be covered by the initial margin. Otherwise, the margin will need to be topped up.  We call that topping up the maintenance margin.

So it is important to learn about the risk to trade futures contracts before you jump in.