As previously mentioned, futures contracts offer geared, or leveraged, market positions. What does this mean in practice?
If you buy a FTSE 100 Index Future at 6532, your market exposure is £65,320 (6532 x £10). But you don't have to pay this sum to open the position. Instead, you pay what's called an “initial margin”—effectively a deposit—which is a fixed amount per contract based on the likely maximum overnight movement in the contract's price (known as the “scanning risk”).
In addition to the initial margin, each night your position is "marked to market". This means that the daily change in contract value is credited to or debited from your account.
So your total margin requirement is made up of two elements:
TOTAL MARGIN = INITIAL MARGIN + VARIATION MARGIN
When you buy or sell a futures contract from a broker, in practice, the broker has an agreement with the Clearing House, and you have an agreement with the broker. There are predefined rules regarding how much margin the broker is liable to pay the Clearing House, but the initial margin the broker charges you is at their discretion. Your broker will probably want a sum in excess of the initial margin in order to cover daily margin fluctuations.
Once you've bought or sold the contract, your position is marked to market against the daily settlement price, and running profits are either added to your account or must be paid out. This is called variation margin.
When you come to "close out" your position (by selling if you bought as an initial trade, or buying if you sold to open it) the initial margin is refunded, and the net profit or loss is realized. The majority of your profit or loss will probably already be in your account with the broker, as it's been adjusted on a daily basis. The balance for the day should be received the following morning.
This example looks at a trade where two FTSE 100 Index Futures have been bought at an offer price of 6522. We'll assume here that the initial margin charge is £3000 per futures contract. So you've got to pay £3000 per contract to cover the risk of holding the position overnight.
At the end of the day, the futures price has risen to 6530. Your position ("marked to market" against the settlement price) has accrued 8 points in profit (6530 - 6522), multiplied by two contracts. This will be received in variation margin.
Let's assume that the following day, the futures price rises again, this time by 50 points to 6580. The variation margin now due to you is 50 x £10 x 2 contracts.
On the third day the price starts slipping and you decide to take profits at a futures price of 6560. This price is 20 points lower than the previous day's settlement price. You are therefore liable for 20 x £10 x 2 contracts in variation margin.
Adding up the cash flows over the holding period gives you the net profit or loss on the contract, in this case +£760.
Notice that you get the same result by subtracting the selling price from the purchase price and multiplying it by the value per point, and also by the number of contracts. So:
Sold price (6560) - Purchase price (6522) = + 38
+ 38 Points x £10 per point x 2 contracts = + £760
Assuming commissions of £10 per contract on both the buying and selling legs, total commissions in this case would be about £40. So, profits after commission are reduced to £720: a net return of just over 12% over 3 days on our initial margin of £6000.