What is the Ante to get in this Game?

In one of my recent Futures classes I was instructing, a student was having some difficulty understanding what a Performance Bond or Margin is in Futures trading. We spent a little more time on the subject than usual because I like to take my classes forward as a team and never leave anybody behind. During the next break I also had a one-on-one conversation with him about what a Performance Bond/Margin is. This is not unusual for a new Futures trader who is coming from trading a cash account in the Equities markets to trading a margin account in the Futures markets.

The next day the student arrived and explained to me how he came up with an analogy so he could understand this concept of margin. To him it was like playing poker and to get in the game a player must put up an ante. The ante is kept in the pot until all the players have placed their bets and the hand has been played. Once the hand is over the losers would leave their ante in the stack of chips and the winner would receive the stack of chips giving him/her more chips to play future hands with. Meanwhile the losers of the hand would have less chips in their stack. Just like the poker player who puts up a few chips (ante) to control the entire stack of chips placed by all players, the Futures trader only puts up a small percentage of the entire contract size (3-9% usually) to control 100% of the value of the contract.

In class we usually go to the Chicago Mercantile Exchange Group (CMEGroup) website to view the different margin requirements for all the different Futures products that trade on that Exchange. For this article I would like to discuss how the Inter-Continental Futures Exchange (ICE) posts their margins and how they may appear to be a little different than we are used to seeing on the CMEGroup website.

When looking to see how much capital is required to be in a traders account to meet the margin requirements we typically see two columns listed:

Initial Margin Maintenance Margin

Think of Initial Margin as the amount required to initiate a new Futures position. If you buy or sell a Futures contract you have initiated a new Futures position.

Think of Maintenance Margin as the amount of capital that will need to remain in the traders account after the initial day of opening the Futures position. Maintenance Margin is always less than Initial Margin. This amount will stay in an escrow (unavailable to use for any new positions) until you close your position. Once the position is closed that amount plus or minus any profits or losses and commissions will be returned to your account.

Now we will look at a Performance Bond/Margin page from the ICE Exchange and see some perhaps new terms you have not heard of before. I will explain here what each of them mean and then you will know exactly how much capital is required for any United States Futures Exchange to trade a Futures contract. Keep in mind that these margin amounts are per contract. Multiply the number of contracts you are trading by the margin and you will be aware of the total amount of cash needed to trade with. Figure 1 will show the ICE Exchange Sugar #11 margin requirements.

Let’s look at some terms that may not be familiar to you. Notice that there are two columns:Just like the CMEGroup, a trader can find the Initial and Maintenance margin requirements. As of this writing if a trader were to enter a position (buy or sell) in the Sugar #11 contract he/she would be required to have a minimum of $1,595 per contract in their account on the first day they initiate this trade. If they continue to hold the trade past the next trading day they will get a reduced margin (maintenance margin) of $1,450. The net difference of the two margins $145 is then deposited back into the trader’s account and is immediately available to be used however the trader decides.

Speculative Hedge/Member

The column for Speculative refers to the margin requirements that a speculator in the Futures market would have to use. A speculator is a trader who looks to profit by being correct on market direction and has no desire to take delivery of the underlying physical Commodity of the Futures contract they are trading.

Just to the right you will notice the column Hedge/Member. This column is used to provide margin requirements for Commercial traders who use the physical Commodity in their line of work and may intend to take or make delivery of the underlying Commodity. Next to Hedge you see Member. Futures Exchanges sell memberships to individuals and firms. If you are a member of a Futures Exchange you are eligible for this reduced margin just like the Hedger (Commercial Trader).

Looking at the Initial margin required in the two different columns you may notice that one is less than the other. The Exchanges feel that speculators are a little more risky. Typically speculators are undercapitalized and less informed of the market they are trading. Therefore the Exchanges usually ask for more margin from Speculators to offset this additional risk.

Hedge/Members on the other hand get a reduced margin. Partially because the Exchanges know these parties will be trading large contract size and the Exchange would like to keep them as customers to earn more for each transaction. Mostly the reduced margin comes from the credit worthiness of Hedge/Member participants. Hedge traders usually have good quality lines of credit at banks and also they usually own the cash Commodity that can be used as collateral if need be. Owning the cash Commodity also makes the Hedger long the market already, when the Hedger sells a Futures contract against this position he is said to have hedged his bet.

Figure 2 below shows the margins for Spread traders on the ICE Exchange. We will look at the Intra-Commodity (Calendar) Spread margins for the Sugar #11 contract.

ICE Exchange will list tables similar to Figure 2 for all the Spreads traded on their Exchange. Each Spread will have a table for Initial Spread and Maintenance Spread margins. There is also a different margin rate for Speculators and Hedge/Members who trade Spreads.

The main difference between CMEGroup and ICE descriptions of margins is how the ICE list their contract months as “Tiers”. Regardless of which Exchange a Commodity trades on there are always multiple months of the same Commodity trading simultaneously. Fig 3 will show an example of some of the Sugar #11 contract months that trade throughout the trading day on the ICE Exchange.

July 2012 = Tier 1Referring back to Fig 2 we notice the term “Tiers”. ICE refers to Tiers as contract months and years. Below is a list of the first 4 Tiers of Sugar.

• October 2012 = Tier 2

• March 2013 = Tier 3

• May 2013 = Tier 4

As an example, if we were long July Sugar and short March Sugar we would look up Tiers 1 & 3 (Fig 2) where they meet and we would need $550 for the margin requirement.

These are some of the differences between the way Exchanges post their margin requirements. In the end they mean about the same thing, but just like traveling to a foreign country the language spoken may be different.

“In the absence of clearly defined goals, we become strangely loyal to performing daily trivia until ultimately we become enslaved by it.” Robert Heinlein