How Do You Buy & Sell a Futures Contract?

By: Keith Cotterill

The following is an excerpt from Keith Cotterill's Don't Tell the Professionals

In order to buy and sell Futures contracts you have to open an account with a registered broker and deposit funds.  In futures trading this is known as a “margin” account.  Unlike everyday business where companies allow credit, trading futures contracts requires you to deposit funds with a broker before being able to buy and sell in the markets.  This gives security to the exchange knowing that you can cover your potential losses.  What could be worse than having a $1,000 profit on a trade if you didn’t get paid?

What is Margin?  (Also Known as Initial Margin)

Margin is a small deposit that is required by the exchange for a trader to buy and sell futures contracts.  The margin (deposit) figure is calculated by the exchange at the end of each trading day.  Margins will vary according to the volatility of the underlying futures contract market.  If prices are volatile the exchange will ask for higher margins, and if the market is quiet they will remain more or less the same or lower. 

For example, a margin of $2,000 per contract was required by the exchange to buy and sell coffee futures in 1994.  Six months later the margin on coffee was $28,000 per contract.  The reason for this huge increase was that the underling coffee price had exploded in April from 70 cents per pound to over $2.63 per pound in just three months.  In one days’ trading during the volatility, coffee prices rose $11,000 per contract.  With this sort of volatility and price swings, the exchange raised the margin to cover your position if you were on the wrong side of the market.

What is Maintenance Margin?

Maintenance margin is the amount of funds you must have available in your account to hold a position in the market.  The exchange sets equity (fund) levels that they allow your account to fall to before requesting additional funds.

Should your account fall below this level, then you will receive a margin call from your broker.  You will be asked to deposit additional funds in order to hold any position(s) you already have in the market at the time of the margin call.  If you can’t deposit additional funds you will be asked to close some or all of your positions in order to meet the call.

When Do You Get Paid?

Futures contracts are standardized, so working out your profit or loss is relatively simple.  The exchange has to balance the books; therefore, losses are added or deducted from your account at the end of each trading day.  If you have a profit on your position, your profit will be added to your account (credited) and if you have made a loss, the amount will be deducted from your account (debited).  All accounts must balance before the opening of trading the next business day.  If you are a positional trader your account will change at the end of each trading session.  If there’s an increase or decrease in the price of the contract(s) value, this will be reflected in your account’s balance.

What is a Limit Move?

If you look at a copy of your margin sheet, you will see a column headed Daily Trade Limit.  Using an example, under the heading GRAINS you see wheat futures with a daily trade limit of 20 cents = $1,000 (subject to change by exchange).  What this means is that, if wheat trades up or down in price by 20 cents (the price limit) during the trading session, then trading will be halted.  On a price chart this appears as a horizontal line.

What is Limit Up?

‘Limit up’ means that the market has moved UP in price by its allowable daily limit.  In the wheat case above, by 20 cents.  The mechanics of a LIMIT UP move is that there are no traders on the floor who are prepared to take the other side of the trade because everyone wants to buy, i.e. there are more buyers than sellers.

What is Limit Down?

‘Limit down’ means that the market has moved DOWN in price by its allowable daily limit.  This time there is no one on the floor prepared to buy, i.e. there are more sellers than buyers.  A limit move is shown in a price chart as just the closing tag.  A limit move shows no trading range (a high low and close).