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Margin Account - Definition
A trading account that allows collateral based trading.
Margin Account - Introduction
Margin accounts are accounts that allows you to trade by borrowing assets from the broker with a small deposit (the collateral). This is known as to trade "on margin". Many financial instruments require margin accounts; Futures, options as well as stocks. Yes, you need margin accounts in order to buy stocks on margin or short stocks as well. Futures trading accounts are margin accounts as the nature of futures contracts allow traders to control a large contract with just a small deposit.
This tutorial shall explore the nature of margin accounts and how margin accounts work in futures trading.
What is Margin Account in Futures Trading?
In futures trading, margin accounts are simply the trading account that you have opened in order to trade futures.
All futures trading accounts are automatically margin accounts due to the fact that futures are traded on collateral. Margin accounts are basically trading accounts that allow traders to borrow assets with small cash deposits resulting in leverage. In fact, most futures trading margin accounts can be used for stock and options trading as well. You also need margin for buying stocks on margin or shorting stocks. As such, margin accounts are not something specifically invented for futures trading.
Margin accounts are needed in futures trading due to the fact that futures are traded on margin. You pay an initial margin in order to go into a contract for the trading of a lot more assets than the amount deposited as initial margin would be able to. Profits are then added to this margin account while losses taken from it through the mark to market process.
How Margin Accounts Work?
Margin accounts allow the account holder to trade on collateral or deposit. This means that margin accounts allow the account holder to borrow from the broker. Translated into futures trading terms, this means the ability to open a futures position by placing a small deposit known as the initial deposit. Futures trading is leveraged trading due to the ability to control more assets using lesser money. This ability to enter into an agreement to trade more assets than you have the cash for is a form of "borrowing", just like when you buy more stocks than you have the cash for in a stock margin account. Margin accounts give the holder access to this trust from the broker without which, collateralized trading like futures trading and stock shorting cannot be done.
Essentially, margin account holders have the trust and rights granted by their broker to trade leveraged instruments and to trade by borrowing assets. This increases the risk of default faced by brokers versus simple cash accounts. This is also why margin accounts are slightly more complex to open than cash accounts. Most brokers would require the applicant to have a certain degree of experience in trading or a higher minimum deposit in order to open a margin account. In fact, credit reviews may also be performed on an applicant in order to assess the credit default risk of the applicant.
Indeed, margin accounts work because brokers are willing to lend to and guarantee the performance of a futures trader. Without this trust, futures trading cannot take place. This is also why futures trading cannot take place in simple cash accounts.