When trading futures, there are a few constraints or limits that you are always working against unlike like purchasing stocks. The first limit or boundary is time. When you buy a company's stock, it's yours forever unless one of these events occur: you sell it, the company goes bankrupt, the company gets bought out, or absorbed by another company, or a company buys its own shares to return to a privately held company. Unlike owning stocks, futures have a time limit. Each contract you purchase eventually expires and the expiration date is something you must know before you purchase the contract because as a smaller investor you must liquidate, or close your position, before the expiration date. If you don't and you own the contract on expiration then the consequence is that you must take delievery of the underlying asset as set forth by the futures contract and you would owe alot more than what you thought you owed (this generally doesn't happen anymore because of stricter rules governing brokers and accounting practices).
The second boundary futures traders have is money, or capital. Unlike owning stock, if you purchase shares at $20 and unfortunately they go down in value to $3 a share. Your broker will not call you for more money. The reason is when you purchase shares you typically purchase them outright with cash on delivery. However, there are investors who purchase shares using credit, or margin, but in this example, the typical purchase of stock is like purchasing groceries - full payment is due immediately upon receipt. But if you lose a lot of money with your futures contract, you will get a phone call from your broker asking you to make a decision. You will be asked to either close the losing position or add more money to your account by the end of the business day.
Well, when you purchase a futures contract you're actually allowed to purchase the contract for a fraction of what the total delivery of the contract is worth and the exchanges set the initial purchase price of the contract by setting what's called the "initial margin". This is the amount of money you need in your account to buy or sell one futures contract. As an example, one corn contract only requires $844 versus one regular crude oil contract from the NYMEX requires $6,062 while one regular SP500 contract at $20,000. The E-mini SP500 however only requires $4,000 since it's only 1/5 the value of a regular, or full, contract. However after you purchase the contract, the value of your account is adjusted daily. Money flows into your account if you make money and money flows out of your account when you are losing money. It that sense your futures account is similar to your bank's checkbook account except you don't need to write a check because you don't know who the other counterparty is who owns the opposite position to your futures contract. So enters the clearing firm who is responsible for tracking the accounting records and balancing everyone's accounts. Now, if you lose a little money nothing happens, but if you're losing a lot of money your broker will call you because the clearing firm will notify the broker that your account is soon to become a liability. Remember that futures are settled each day and everyone who plays must pay immediately. So if your account were to go into the red, then you would owe money and we all know how hard it is to collect money from someone who owes it. So the system is designed to protect all of the participants by avoiding this possibility, thereby preventing you from going into the red, or owing money. This protection mechanism is known as the "margin call" and this call from your broker is triggered when your account falls below the "maintanence margin". If your account falls below this maintanence margin limit then another is triggered. If you elect to keep the losing contract, you will need to add money to your account to restore it to the initial margin level. So the maintanence margin is to protect the other participants from you owing them money and is not used set your account's value. The reason for this is simple. If you restored your account's value to the maintanence margin level and the market went against you the following day, you would forced to send more money again. Quite simply, this is too much work for for everyone. You can't be bothered with transferring funds every day and your broker certainly doesn't want to call every day collecting more money from you. So restoring your account to the initial margin level gives you a cushion for additional losses. But of course there are times when prices move so viciously that even restoring your account to initial margin levels each day is required. And example of this in the SP500 that would be four days in a row of -18 points each day. BTW, when this occurs the exchange typically increases the initial margin so that system doesn't break down from a lack of money and the increased volume of work required to reconcile the transfer of funds from tens of thousands of participants. As an example, the natural gas contract's initial margin was at a high of $25,000 where it is currently $5,400. So price volatility is evaluated daily and the exchange can change the rules daily! (This is another rule of trading. The rules change quickly.)
As an example, you buy one E-mini SP500 contract at 1120.0 and you have $4,500 in your account. The broker automatically checks your account to see if you have $4,000 in it; and you do. So the purchase is authorized. Now the market climbs to a high of 1133 but settles at 1122. The high of 1133 is meaingless to your account. That's the same as saying I could of win lotto last week. The 1122 is the important number because that is what is used to clear your account for that day, so your account grows by $100 to $4,600 (2 points profit x $50 per point value). Since you made money, you decide to hold the position overnight. The next day comes but the price drops to 1105 by the close. Your account value is now worth $3,750 (-17 points x $50). The good news is that your balance is above the maintanence margin, which is set by the exchange at $3,200. (This is another important boundary as will be explained through this example.) This means you can still hold this contract without adding more money to the account. The third trading day starts but it's a terrible day. It gaps open lower 10 points and drives down to limit.-55 points (Oops, this is the third limit to trading futures that you should know. Sorry.) Fortunately, your account does have enough money to cover a 55 point drop in price. You have $3,750 which is worth 75 points. So you're thinking, "wow, I just escaped a disaster". All the market has to do is rebound over the next 30 days (because you have 30 days left to expiration) and you'll get your money back. But you would be wrong,
At that moment in the day, your account value is only worth $1,000 (-55 points x $50 substracted from $3,750) which is below the maintenance margin. Unlike the 1133 high, which was meaningless to your account. Intraday lows (since you're long the market while intraday highs are important to those short the market) are primary concern of the clearing firm. So your broker calls you mid day and asks what do you want to do. But when he/she calls you remind them that you have $1,000 of value in the account. Now your broker may or may not allow you to continue trading. This is where we get into a little gray area because some brokers strictly adhere to the rules and some do not. The point here in this example is that you need to either close the position or add more money via a bank wire transfer. But the amount that you need to transfer isn't to rebuild the account to the maintanence margin level of $3,200, it's the amount that brings you back to the initial margin level of $4,000. That's the rule. Once you fall below the maintanence margin level, you need to return to the initial margin level. So in this case if you elect to keep this trade, you would need to send your broker $3,000. This amount is computed by subtracting you current account value from the required amount needed to return to the initial margin level. In this case, the $1,000 of remaining value is added to the $3,000 to arrive at the required $4,000 level. The fact that you started with $4,500 doesn't mean anything. The value of your account at this moment is below what is required to own the right to hold this contract. However, if you elect to close the position because you don't have anymore money to send then you out of the market without any chance to recover your losses.
So you see, with futures trading bad things can happen quickly. In this example, if only took three trading days to lose your money and you had no means to hold on or hope for a better tomorrow. In this example, you lost $3,500 in three days. Bang, that's it; you're out. With stock, you own it and it goes down in value you still can hope for better days ahead, but in the futures market, if you're down and you're out of money, you'll be spit out as a casualty of war. You can't play anymore.
Understanding the rules of futures trading is vitally important before you enter this arena. Knowing the boundaries is the first step in making the decision that you're ready for this type of trading. This quick explanation introduces you to the governing body responsible for setting the rules, the exchanges, and the enforcers, the brokers. The exchange sets the limits such as expiration dates, margin levels, and the price limits for each contract while your broker is responsible for insuring that the money management rules are enforced. However, if your broker makes a mistake and doesn't give you a margin call you are still ultimately the one responsible for the consequences for every trade you make. The rules are quite basic and simple so that you can't blame anyone else for your losses.
This adds another reason why switching from investing in stocks to trading futures contracts is difficult because it requires discipline and oversight. Trading futures requires a small amount of time each day to review all of day's transactions and cancelled orders, so that any discrepancies can be identified and remedied before the start of the next trading day. This simple but prudent step is often overlooked by novices and is the source of many problems Many novices assume that there aren't any problems and that their wishes (orders) are faithfully executed as instructed and that they never make a mistake. The problem with any assumption is that in fact mistakes do occur, whether they are the result of your actions or due to others. You can never assume that everything transpired as you remember it. Mistakes happen; lingering orders got filled that you thought you had cancelled; your limit order didn't get filled despite the fact that the price was hit; etc.
You must be forewarned, futures trading is fast and furious. So take the time to understand the rules and boundaries so that you know the consequences before you begin trading futures.
Perhaps now you can understand the statement that was made, that only one day was a financial strain. On the day that rose 20 points, those who were short the market lost 20 points, which more than likely put them on the margin call list. When this occurs, this forces some traders out of the market and they are forced to buy. This "buy" is to offset and close their open sell position. This is called a short squeeze when the market rallies hard for several days and those selling the market short are forced out of the market. The fact that these traders must buy at any price while under duress drives prices even higher. Of course when they have been squeezed out of the market, prices retreat as the calamitious event (for those traders as they are now broke) is over. BTW, in the futures market buyers can also be squeezed out of the market when prices drop quickly. That's why when you see a big down day, there's usually some follow through the next day. Some of those traders get a margin call and they are forced out of the market.
This short example helps you to first understand the basics of futures trading, but as you can begin to think about these facts, you may gain new insights as to why prices move the way they do. This example doesn't explain why prices move quickly in the first place, but when they do, you can now understand the "snowball" effect that rapidly changing prices have and devestating consequences that they have on trader's accounts. Now that you know the mechanism at work, watch what happens the next time you see a strong up or down day in the markets. The response will tell you how many investors were forced out of the market. If they had a lot of money behind them then the expect little follow through, but if they didn't have much money in their account then watch how much more prices continue in the same direction. This is how the markets can smell blood as it hunts for the weak.
©2004, The Small Investor's Software Co.