The next few sections are drawn from Douglas Breeden, "Some Common Misconceptions about Futures Trading."
One of the most common mistakes that a small investor makes in futures trading is considering the margin on the futures contract as the investment. Margin is a deposit -- usually 5--10% of the contract's value -- required by the futures exchange from both the buyer and the seller of the contract. Margin helps to ensure that both buyer and seller will perform as specified in the futures contract.
It is best to look at an example. This historical example is taken from the early 1980's - a period of unprecedented interest rate swings. In May 1981, the initial margin required by the Chicago Board of Trade from both buyers (longs) and sellers (shorts) of U.S. Treasury bond futures contracts was $4,000 per contract. A June futures contract calls for delivery of a Treasury bonds with a face value of $100,000 and a current market value of approximately $65,000. The margin required is about 6% of the value of the contract. Furthermore, the exchange stipulates that a margin balance of at least $3,000 per contract be maintained at all times.
If on the first day after a trade was made, the futures price falls from 65.00 per $100 face to 64.50, the buyer or long loses $500 ($0.50 x 1000) and the seller or short gains $500. This amount is actually transferred by the buyer's broker to the seller's broker. The seller can take the $500 out of his brokerage account and use it in other investments if he so desires. The buyer in the futures contract has his brokerage account debited for $500, leaving an account equity of $3,500. Since this is in excess of the $3,000 minimum maintenance margin required by the exchange, no additional margin need to be posted. In exchange for the $500, the futures contract that was initiated at a price of 65.00 is automatically rewritten by the exchange to specify delivery at a price of 64.50, the current market price for that contract. By this process of marking to market, all futures contracts for the same commodity and delivery date specify the same delivery price, making them identical contracts.
Now consider what happens the next day. The June Treasury bond contract falls from 64.50 to 63.50. The long has a loss that day of $1,000. which is the short's gain. After the contract is rewritten with a price of 63.50 and the $1000 is transferred from the long to the short, the long's equity drops to $2,500. As this is below the $3,000 maintenance margin required by the exchange, the long receives a margin call from his broker. The long must deposit $1,500 to raise his account balance to the initial margin level of $4,000. Thus, in this example, the buyer has had to deposit a total of $5,500 with his broker so far. Clearly, the initial amount of $4,000 is not the total at-risk investment required to take and hold a Treasury bond futures contract.
Table 1 shows the cash flows for the long position from April 1 to May 29.
Cash Flows of a Long Position in
June 1981 Treasury Bond Futures: April 1 - May 29, 1981
| Date | June 1981 T-bond Futures Price |
Daily Gain or Loss |
Account Balance | Margin Deposit | New Account Balance |
Total Deposit | Total Profit or Loss |
|---|---|---|---|---|---|---|---|
| 4/1/81 | 67.03 | - | 0 | $4,000 | $4,000 | $4,000 | 0 |
| 2 | 66.19 | -840 | $3,160 | 0 | 3,160 | 4,000 | -840 |
| 3 | 65.56 | -630 | 2,530 | 1,470 | 4,000 | 5,470 | -1,470 |
| 6 | 63.34 | -1,720 | 2,280 | 1,720 | 4,000 | 7,190 | -3,190 |
| 7 | 65.38 | +1,340 | 5,540 | 0 | 5,540 | 7,190 | -1,650 |
| 8 | 64.50 | -880 | 4,660 | 0 | 4,660 | 7,190 | -2,530 |
| 9 | 65.25 | +750 | 5,410 | 0 | 5,410 | 7,190 | -1,780 |
| 10 | 64.50 | -750 | 4,660 | 0 | 4,660 | 7,190 | -2,530 |
| 13 | 64.19 | -310 | 4,350 | 0 | 4,350 | 7,190 | -2,840 |
| 14 | 64.69 | +500 | 4,850 | 0 | 4,850 | 7,190 | -2,340 |
| 15 | 63.78 | -910 | 3,940 | 0 | 3,940 | 7,190 | -3,250 |
| 16 | 63.53 | -250 | 3,690 | 0 | 3,690 | 7,190 | -3,500 |
| 20 | 64.50 | +970 | 4,660 | 0 | 4,660 | 7,190 | -2,530 |
| 21 | 64.16 | -340 | 4,320 | 0 | 4,320 | 7,190 | -2,870 |
| 22 | 63.97 | -190 | 4,130 | 0 | 4,130 | 7,190 | -3,060 |
| 23 | 63.88 | -90 | 4,040 | 0 | 4,040 | 7,190 | -3,150 |
| 24 | 63.50 | -380 | 3,660 | 0 | 3,660 | 7,190 | -3,530 |
| 27 | 63.28 | -220 | 3,440 | 0 | 3,440 | 7,190 | -3,750 |
| 28 | 63.38 | +100 | 3,540 | 0 | 3,540 | 7,190 | -3,650 |
| 29 | 62.56 | -820 | 2,720 | 1,280 | 4,000 | 8,470 | -4,470 |
| 30 | 61.88 | -680 | 3,320 | 0 | 3,320 | 8,470 | -5,150 |
| 5/1/81 | 62.31 | +430 | 3,750 | 0 | 3,750 | 8,470 | -4,720 |
| 4 | 60.41 | -1,900 | 1,850 | 2,150 | 4,000 | 10,620 | -6,620 |
| 5 | 59.97 | -440 | 3,560 | 0 | 3,560 | 10,620 | -7,060 |
| 6 | 60.38 | +410 | 3,970 | 0 | 3,970 | 10,620 | -6,650 |
| 7 | 61.63 | +1,250 | 5,220 | 0 | 5,220 | 10,620 | -5,400 |
| 8 | 61.75 | +120 | 5,340 | 0 | 5,340 | 10,620 | -5,260 |
| 11 | 60.31 | -940 | 4,400 | 0 | 4,400 | 10,620 | -6,220 |
| 12 | 60.75 | -160 | 4,340 | 0 | 4,340 | 10,620 | -6,280 |
| 13 | 60.69 | -60 | 4,280 | 0 | 4,280 | 10,620 | -6,340 |
| 14 | 62.25 | +1,560 | 5,840 | 0 | 5,840 | 10,620 | -4,780 |
| 15 | 62.41 | +160 | 6.000 | 0 | 6,000 | 10,620 | -4,620 |
| 18 | 63.84 | +1,430 | 7,430 | 0 | 7,430 | 10,620 | -3,190 |
| 19 | 62.97 | -870 | 6,560 | 0 | 6,560 | 10,620 | -4,060 |
| 20 | 63.19 | +220 | 6,780 | 0 | 6,780 | 10,620 | -3,840 |
| 21 | 62.39 | -600 | 6,180 | 0 | 6,180 | 10,620 | -4,440 |
| 22 | 63.50 | +910 | 7,090 | 0 | 7,090 | 10,620 | -3,530 |
| 26 | 64.09 | +590 | 7,640 | 0 | 7,640 | 10,620 | -2,980 |
| 27 | 63.91 | -180 | 7,480 | 0 | 7,480 | 10,620 | -3,140 |
| 28 | 64.69 | +780 | 8,260 | 0 | 8,260 | 10,620 | -2,360 |
| 29 | 64.75 | +60 | 8,320 | 0 | 8,320 | 10,620 | -2300 |
We usually think of an investment as a negative cash flow today for some future expected return on that initial cash flow. Futures is a little complicated because the only cash flow out today is the margin. In fact, large clients are allowed to keep their margin in Treasury bills -- so it is hard to see any cash outflow today. The best way to view the investment in a futures contract is to treat the investment as if the entire value of the contract were placed in Treasury bills or a money market fund at the inception of the contract. As margin is needed, funds are simple transferred out of the money market fund and into your commodities account. Excess margin is transferred back into the money market fund to earn interest. In the Treasury bond futures example in Table 1, this would mean that the investment should be viewed on April 1 as $67,020 in June Treasury bonds. The return on this investment has two components: (1) the interest earned on funds in the money market fund at rate r, and (2) the gain or loss on the futures contract expressed as a fraction of the total investment. The portfolio returns is
Most futures traders employ leverage by not setting aside the full value of the contract in a money market fund. Define leverage to equal to the ratio of the value of assets controlled to the value of funds set aside investment. For example, if $20,000 were set aside in a money market fund for the Treasury bond contract's assets worth $67,030, the leverage ratio would be:
From this equation, it is straightforward to compute the standard deviation of your return on equity from your leverage and the standard deviation of the percentage change in the futures prices:
Based on historical relationships, an equity amount equal to 5 to 8 times the margin required by the futures exchange results in a standard deviation of return on equity that is of approximately the same as the standard deviation of a typical stock (10% monthly). Of course, this is just a rule of thumb, but it does give some guidance on the funds that should be set aside in a money market fund for a futures contract.
For more information on margins, see Sample Margin Tables .