Futures and margins
How futures and margins work
Let’s take an example on how futures and margins work
You are a trader and you just bought your first wheat futures for $585 a bushel. What happens after that?
1. The exchange asks you to deposit your initial margin, typically 10% of the notional. Now a futures doesn’t correspond to one bushel, but 5,000 instead. So you have to deposit 10% x $585 x 5,000 = $292,500 in a bank account controlled by the exchange. You have to deposit that initial margin, whether you are a buyer or a seller of the futures.
2. Every day, the exchange will ask you to receive or pay your daily gain, in payments called variation margins. The exchange uses a reference price for the day called the Daily Settlement Price (DSP). The exchange “calls you on margin”. These payments are mandatory and payable immediately (typically T+1, in the morning.
3. On the expiry day, the exchange uses as final settlement the price of physical wheat, based on the reference physical market (where, what time, how to measure it…). This price is called the Exchange Delivery Settlement price (EDSP). If you are long that futures, you are obligated to take delivery of those 5,000 bushels, at the indicated price of $625. If you are short, you have to make the delivery at that price. Either way, you settle (pay/receive the cash, take/make delivery, at the pre-agreed location…) according to the contract settlement specifications.
4. If you look at all your payments, you find that it is equivalent to buying these 5,000 bushes at 625 – ($625 – $585) = 585$. You end-up in possession of 5,000 bushels of wheat, which you have paid at the price of your initial futures trade.
5. The exchange returns your initial margin to you.
If you look at all your payments, you find that it is equivalent to buying these 5,000 bushes at $625 – ($625 – $585) = $585.
=> You end-up in possession of 5,000 bushels of wheat, which you have paid at the $585 price of your initial futures trade.