Options Education

Valuing a Contract and the Capital Required to Trade It - Part 2

Valuing a Contract and the Capital Required to Trade It - Part 2

A short review from Part 1 of this article shows that each Futures contract has its own unique specifications. In these specifications is the size of the contract and from that we can determine, how much the entire contract is worth.

Table 1 shows some of those dollar values for selected Commodity Futures.

Contract Value in \$ = Last Price * Contract Size

Table 1

Table 2 shows us the dollar values of the Stock Index Futures.

Contract Value in \$ = Multiplier * Last Price

Table 2

Keep in mind that the contract value in dollars for both tables is per Futures contract. If you trade multiple contracts, then simply multiply the number of contracts by the contract value in dollars and you will have the gross value of contracts you are trading. Looking at the Gold contract we can see that trading just one contract is worth \$138,490 (as of this article date). If you were trading 5 contracts, the gross value would be \$692,450!! Not many traders have almost æ of a million dollars laying around to trade with. For this reason, Futures markets have something called Margin/Performance Bonds.

Margin/Performance Bonds are known as good faith money you must have in your trading account. This amount of capital assures your brokerage firm and the clearing firm that you are good for covering any losses you may sustain while in a trade. For the rest of this article, I will refer to this as Margin instead of Performance Bonds. Margin is the same thing as Performance Bonds in the Futures Industry.

Using Margin is how we create the leverage associated with the Futures markets. If we were going to invest in 100 Troy ounces of Gold in the cash market (buy the physical Gold and store it), we would have to pay \$138,490 plus associated transaction, delivery and storage fees. The Futures markets allow you to buy this same Gold by utilizing a contract for future delivery (buying physical Gold) if you wish, on Margin for about 5% of this \$138,490. Currently, the Gold contract would require you to initially have \$6,075 (plus commissions) per contract you are going to trade. Can you see the remarkable leverage here? In this example, the leverage is a little better than 20:1. This means that for every dollar you use for margin, you are controlling \$20. Instead of tying up capital for the full value of the contract, you can use just 5% of that amount and invest the difference in other assets. This allows for better diversification of your portfolio.

Table 3 shows us the percentage difference of using all Cash or a Futures position.

Table 3

An investor who purchases Gold with all Cash and has a profit of \$5,000 will see a 3.61% return on his investment. A trader who uses leverage in the Futures markets will see the same \$5,000 profit, but their percentage return is a whopping 82.3% plus the additional profits they could have made with a diversified portfolio with extra cash available to them because they used leverage.

Just like the Futures Exchanges create the contract specifications for Futures contracts, they also set these Margin rates for any positions that are held beyond the regular day trading session. All brokerage firms must charge you these minimum Margin amounts set by the Exchanges. Brokerages can charge more, but never less. All day trading Margins are set by individual brokerage firms and can vary from one brokerage to another and are usually much less than overnight Margin rates.

This link will take you to the Chicago Mercantile Group Exchange (CME Group) Margin website where over 85% of the world's Commodities trade.

http://www.cmegroup.com/wrappedpages/clearing/pbrates/performancebond.html

On this page you will see a list of Commodity sectors and next to that, a list of Outright Rates, Intra-Commodity Rates and Inter-Commodity Rates. For purposes of this article, you will be looking at the column of Outright Rates. Let's click on the Agriculture sector Outright Rates link. Then scroll down to Live Cattle. Table 4 shows this section in detail.

Table 4

Let's define these items:
• Spec ñ Abbreviation for a Speculator. This is a person or entity that speculates on price movements in anticipation of profiting. This class of trader is considered to be at the most risk by the Exchanges and therefore, will pay more Margin.
• Hedge ñ This is an entity that uses the physical Commodity in their daily line of work and uses the Futures markets to hedge their risk associated to these Commodities. Exchanges find Hedgers to be very credit worthy and lower risk so they always get a reduced Margin rate.
• Member ñ Each Exchange has memberships available by buying a seat on the exchange. These can be very expensive, but to large traders and institutions, they can find many benefits to having access to the trading floors. Members get a reduced Margin rate because membership has its advantages.
• Initial Margin ñ Amount you must have in your trading account per contract before the close of the regular day session on the first day of the position. Think of this as capital required to initiate an overnight trade.
• Maintenance Margin ñ Amount you must keep in your account per contract for each day you hold this position after the first day. Think of this as capital required to maintain your current position.
Now that we know where to find these Margin rates and how the Exchanges set them, let's look at what would trigger something called a Margin Call. We will refer to our Live Cattle example (Table 4) again. For simplicity, I am going to assume our example trading account currently has a balance of \$1,350. Our swing trading strategy calls for entering the Live Cattle market on the close of the day session. We enter our order with the brokerage firm and we are in our Live Cattle position on the close - can be either short or long the market, Margin rates are the same for either.

Margin Calls are simply notifications that your account balance has slipped below the required Maintenance Margin levels required by the Exchanges. Your brokerage firm will contact you immediately offering you two options
• Replenish your account balance back to the original Initial Margin requirement (\$1,350). This will require you to wire funds that day to the brokerage firm.
• Liquidate your position for you
Margin Calls never come with penalties or fees. You just elect which option you prefer and notify your brokerage of your decision.

My opinion on Margin Calls is to never ever replenish your account after receiving a Margin Call. The reason is this - a good trader will never risk more than 4-5% of their account balance on any one trade. When you get a Margin Call, your account has now fallen almost 25% since initiating the position. This means that if you replenish your account on just 4 Margin Calls, you will wipe out your trading account. If you get a Margin Call, simply instruct the broker to liquidate your position and be thankful because something has happened that has made you hold this losing trade for too long.

What changes the value of these Exchange set Margins?

Margins are based on volatility and risk in each individual market by an algorithm the Exchanges use. If the Exchanges perceive excessive risk to market participants due to this volatility or risk, they will raise the Margin amounts respectively. Once the risk is gone, the Exchanges reduce the Margin back to a more normal rate.

When using Margin, think of buying a house that you are basically putting down a small amount of cash to control a larger investment. In essence, you are creating an escrow using Margin that will be used to offset any possible losses.

"If you are patient in one moment of anger, you will avoid one hundred days of sorrow." Chinese Proverb

- Don Dawson
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