Margin
The Smart Profits Report: Issue #115
Thursday, June 03, 2004
Margin: How to Turn a 10% Bump into a 50% Jump
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
In the crude oil futures contract example from our last installment, our buyer, Joe, bought a NYMEX crude oil contract for $30 per barrel, and our seller, Sue, sold a crude oil contract for $30 per barrel. Yet no money changed hands.
So, how did they consummate the transaction? Both “posted margin” with their respective brokers.
Margin requirements are set by the individual exchanges and, for the most part, are based upon volatility and not price. Unlike buying margin on stocks (that is, “shorting” a stock), margin to trade a futures contract is not a down payment on a loan. It is a performance bond that guarantees to your broker that you are good for a fixed amount of losses.
Receiving Margin Interest Instead of Paying It - Using T-Bills
Because it is a performance bond and not a down payment, you do not have to pay any interest on your margin deposit. Instead, you can actually receive interest while using the money to back up your positions.
How? By posting margin with your broker in the form of a U.S. Treasury bill. Since the T-bill is backed by the U.S. government, it is nearly as good as cash, so most commodity brokers accept it in lieu of cash. Meanwhile, you get to keep the interest.
As of this writing, the margin (or performance bond) required to trade a crude oil futures contract is $6,000. Both the buyer Joe and the seller Sue have to post $6,000 with their brokers for each crude oil futures contract they want to trade. As prices change, money will be physically added to and/or subtracted from their accounts to reflect their ongoing gains or losses.
Important Point: Unlike stocks or the purchase of options, there is no such thing as a paper gain or loss in futures. Both are realized immediately. Gains are physically added to your account (and can be withdrawn) each day, and losses are physically deducted even though you may still hold the contract.
This is where the concept of leverage comes in…
How to Increase Your Take by 500%
A 10% rise in the 1,000-barrel NYMEX crude oil contract, from $30 to $33, will result in $3,000 being credited to buyer Joe’s account. That’s a 50% return on his $6,000 margin. Similarly, that same 10% rise will cause $3 per barrel (or $3,000 total) to be deducted from Sue’s account, causing a 50% loss on her margin. If crude moved far enough against either, that account could go into negative territory.
Either party could be required to add more money to the account in order to meet the minimum margin (performance bond) requirement. This is known as a “margin call.”
If the price of crude oil moved far enough against their respective positions to exhaust the amount of cash in either party’s trading account, that position would be liquidated and that individual would be responsible for any additional money required to bring the account back to zero.
The commission to do this trade should cost no more than $80 per contract. Futures commissions are typically quoted “round-turn,” which includes both the buy AND sell. In our example, both Joe and Sue were able to trade crude oil directly without having to fully pay for the $30,000 it would have cost to purchase 1,000 barrels of crude oil outright. They didn’t have to pay the costs of storage and delivery either.
1,000 Barrels of Crude… On Your Front Lawn? Not Likely
Meanwhile, the mere fact that delivery could take place means the price of the futures contract has to track the actual price of crude oil very closely. The vast majority of futures transactions (upwards of 90%) DO NOT result in delivery. Long and short positions are exited prior to the delivery period.
Crude oil is no different. Indeed, the ease and low cost of trading crude oil futures has made them the most liquid (no pun intended) oil market in the world - to the point where many analysts believe the futures markets actually set the cash price.
As with all futures contracts, crude futures traders do not need to worry about counter-party risk. Each exchange acts as a clearinghouse: It is the seller to all buyers and the buyer to all sellers.
The exchanges perform the same clearinghouse function with futures options. Where options are different is in the amount of risk involved. Unlike futures contracts themselves, when you buy futures options your risk is limited to the amount you pay for them.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- If you’d like to check out the commodity scene yourself, there’s no better introduction than the Chicago Board of Trade’s (CBOT) website. To access its price updates, news stories and history, just visit www.cbot.com.
- Check out our Smart Profits Glossary concerning options terminology, like “margin” or “leverage“.
Related Articles:
- Understanding Options Leverage - The Power of Leverage Is Bigger than You Think
- Commodities - How to Create Your Own ‘Mini Hedge Fund’
- Why Short a Stock when You Can Buy a Put?
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