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Futures margin mechanics

Understanding the mechanics of margin for futures. Initial and maintenance margin. Created by Sal Khan.

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  • stelly orange style avatar for user A. Msa
    I don't really understand what the benefit of the margin account is for the buyer when the futures contract delivery price goes down. Without the margins account he would have to buy the apples for $200, and with the margins account he has to buy them for $190 + give $10 of his margins account to the margins account of the seller! What am I not understanding? Basically I'm trying to ask, what's the use of the margin accounts if the outcome is the same anyway? Just so that the buyer does not feel "stupid" at paying a price higher than the market price? But surely the buyer understands that he does, essentially, still pay a higher price than the market price when taking the transfers in his margin account into the equation?
    (73 votes)
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    • blobby green style avatar for user Matthew Fisher
      The margin is not meant to benefit the parties. Its purpose is to give the exchange a degree of security. The margin essentially means that one party will have to give part of the value promised in advance of the date agreed. This makes it less likely that that party will breach the contract, making it less likely that the exchange will have to pay out under the guarantee it offers. Furthermore, even if one party does default on the contract, the exchange will have less to pay out as guarantee, since part of the value promised will already have been transferred via the margin mechanism.
      (101 votes)
  • blobby green style avatar for user Erika C.
    Hi, I have a question. At the very end of the video, you said that the buyer has to add $15 to return his maintenance margin to the original value of the initial margin. Why would he do this? Wouldn't the buyer eventually realize that all the supposed 'savings' he was receiving from the drop in the price of the future contract was actually coming from his own pocket? Thanks in advance!
    (8 votes)
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    • male robot hal style avatar for user johnsalyers
      2 things can happen: (1.) The buyer can realize he is in a contract for a reason and add the $15 to his account, which really won't lose him any money because in the end he will still have forked over $200 for something he agreed to buy.

      and (2.) He can refuse to add $15 more dollars, and he will lose the $15 (or probably the entire $20) he already set aside as margin and be free to go out and buy a contract on the market. Currently, the price is $185 so he would be getting break-even (or possibly losing $5 if he forfeited the money left in his margin account). If he thinks the market will keep going down, then he can wait for that to happen and buy it when it gets lower. Then he made a smart move. But the market could always go back up! What if it goes back to $200 the next day?! Then he wasted a lot of money. This gives him incentive to just fork over the $15 now rather than go back to the volitile market.

      And what happens to the seller in this case? Well its simple, he gets to keep the $15 margin that was added to his account and go out and get a new contract where someone will pay him $185. So he breaks even and really its like nothing changed from his original $200 contract.
      (28 votes)
  • blobby green style avatar for user vkgoku2012
    wait do you get to keep the margin call that you put up if you do sounds like good deal and your bound to make a profit but if you don't then your pretty much paying higher price.
    (5 votes)
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  • blobby green style avatar for user labeaum1
    I have the exact same question. Margins seem to reintroduce the volatility the forward contract was said to reduce. Can anyone explain how margins reduce volatility for the buyer or seller?
    (4 votes)
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    • blobby green style avatar for user Biz Bose
      First of all, we're talking about futures contracts, not forwards. Futures contracts reduce volatility by eliminating price risk - the risk that the market price will change from what you're willing to pay. Margins reduce volatility by eliminating counter-party risk - the risk that the exchange will end up buying the product because the original buyer disappears without having paid anything.
      (3 votes)
  • orange juice squid orange style avatar for user FishHead
    So the margin is basically a down payment that adjusts over time?
    (1 vote)
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    • blobby green style avatar for user Mark Sinsheimer
      Not really; a downpayment is typically for buyers only. Margins are for buyers and sellers. Also, your analogy to a floating downpayment would probably adjust in the same direction as the price, which is not necessarily the case for margins.

      Margins are collateral required to enter into a transaction. They are determined in function to the riskyness of the commitment to ensure they will be acted upon.

      Margins are adjusted when prices move to compensate for the subsequent advantage or disadvantage resulting from the transaction. If the price movement is in your favor, there is a lower risk you will reneg on your commitment and the margin requirement may be lowered. If the price moves against you, there is a higher risk you would reneg, hence you are called for further margin to keep the position open. If you can't follow, your position is closed using your margin deposit if needed.
      (5 votes)
  • blobby green style avatar for user Mark Velkoff
    Hi there, I don't really understand how this eliminates the volatility of the apple price. If the margin account keeps changing and the seller (or buyer) is at risk of having to put more money in if there's a margin call why would they bother with the futures contract at all?

    Does the futures contract follow the market price? Or does the market price only affect the level of the margin accounts, in which case the price at which the buyer and seller interact is fixed?

    Thanks in advance :)
    (3 votes)
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    • ohnoes default style avatar for user Tejas
      What ends up happening is the buyer will buy the apples at the spot price. However, the margin accounts are basically present to eliminate the risk in the volatility of the spot market. If the price goes up, then the seller has to transfer that amount by which the price increased to the buyer in order to cancel the changes in price.
      (1 vote)
  • blobby green style avatar for user Marshall Stanton
    So would it be fair to say that insurance policies are a form of futures contract, with the premiums being the margin, and the insurer agreeing to "buy" the liability on any damages to the property [car, home, life, etc.] at some future date - the future date being "when the property gets damaged in a certain way."
    (3 votes)
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    • aqualine ultimate style avatar for user Abdulaziz.Saja
      Well, yes I guess you could say. The same case with Credit Default Swaps (CDSs). But I think if we get into the textbook definition of insurance, you'd find that insurance's purpose is to cover your losses only with no chance on making profit but here it's more speculative. The buyer or the seller can got out making handsome profits.
      (1 vote)
  • male robot donald style avatar for user harry park
    does the Future's Contract itself indicate whether it is for the Buyer of the Commodity or the Seller of the Commodity?
    I mean, for all I know, the Future's Contract only holds information on the settlement price, the commodity detail, and the date of settlement.
    How does the Exchange find out if the person holding the Future's Contract is the Seller of the Apple, or the buyer of the Apple?
    Sal should explain these things.
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      A contract is either a contract to buy or a contract to sell.
      If you want to be able to buy the commodity at some set price in the future, you purchase a contract to buy.
      If you want to be able to sell the commodity at some set price in the future, you purchase a contract to sell.
      (4 votes)
  • blobby green style avatar for user William Ruan
    I know futures are supposed to protect against the volatility of markets. With margins, how are futures markets really different from not having a futures market if margins are triggered whenever the price of a commodity, let's say apples, goes up or down?

    Also, if a party were to violate a contract, can't the other party turn to the courts or some other regulatory agency for appeals?
    (3 votes)
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  • blobby green style avatar for user Lindsey Schlabach
    And along the same lines as the previous questions, what if buyer doesn't have $150 do add to his margins? Does he default on the contract?
    (1 vote)
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    • blobby green style avatar for user erwin_dso
      hi,
      You could say that he defaults on the contract. If the buyer refuses to add the extra $15 dollar. The contract is unbound. So the seller can sell his contract to someone else. The loss of the buyer is 20$. In a 'good' contract those 20$ aren't lossed by the buying or selling party. The margin is just there as an assurance to both parties that they will keep their end of the deal (or lose 20$)
      (2 votes)

Video transcript

Let's think a little bit about how margin works for a futures contract. So let's say that the terms of the contract are a 1,000 pounds of apples for delivery on November 15, and we're assuming that this is some date in the future. And right now in the Futures Exchange, the market delivery price, so the price at which the apples will change hand in the future, is $200. And I've written here what the exchange specifies for the initial and maintenance margin, we'll talk about that more in a second. But this essentially means that both the buyer and the seller, for the initial margin, have to put up $20. Sometimes it'll be specified as an absolute dollar amount like I've just done. Sometimes it might be a percentage of the actual delivery price. So they both have to put up $20, and this guy has agreed to buy a 1,000 pounds of apples from this guy on November 15 for $200. So it's essentially $0.20 a pound. Now, let's say that a day goes by, and the next day-- these guys have this contract. This price right here is fixed in their minds. But let's say, the next day, the same contract between two other parties trades with the delivery price of $190. Now, all of a sudden this guy over here feels silly. He's like, man, I'm agreeing to buy something for $200 in the future which some other dude, all of a sudden, has agreed to buy for $190. This guy over here feels really smart. He agreed to sell something for $200 the day before, and now people are selling it for $190. So he's kind of $10 better than the people participating in the Futures Market today. The way market to market works with futures contracts is that the exchange says, well, you know what? I'm afraid that this guy, if things keep moving against him, he's not going to even want to put up the money to buy it at $200 if he can buy in the market at $190 or something lower. So I'm going to reset their futures contract to a delivery price of $190, but, to make things fair, this guy's going to be $10 in the hole. He's getting a $10 deal. If I take the delivery price from $200 to $190, I need to take $10 from this guy, because he's getting a $10 better deal. So from his margin account, I take it from $20 to $10. And then I place the $10 in this guy's margin account. If he's going to get $10 less of a good price on the delivery date, than let me give him the $10 right now. So his margin account will go to $30. Now, this number was 18, 17, 16, or 15, this guy wouldn't have to do anything. But right here, he's triggered his maintenance margin. Actually, he's right at our maintenance margin. So let's say that he goes-- that the next day, this happens a little bit more. It goes down to $185, and we have to do the process again. This guy loses $5, he goes down to $5, This guy will be given $5, so he goes to $35. In order for him to essentially reset the Futures Price, he's been given another $5. Now, this guy has only $5 in his margin account, and the maintenance margin is $10. So triggers a margin call, and this guy's got to find some place to put another $15 in his margin call. Every time you get below the maintenance margin, it triggers a margin call, and you have to refill your margin account to the initial margin. So he has to add $15, so he gets back to $20.