In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit riskof their counterparty (most often their broker or an exchange). This risk can arise if the holder has done any of the following :
- Borrowed cash from the counterparty to buy financial instruments,
- Entered into a derivative contract.
- Sold financial instruments short, or
Margin buying refers to the buying of securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value—the difference between the value of the securities and the loan—is initially equal to the amount of one's own cash used. This difference has to stay above a minimum margin requirement, the purpose of which is to protect the broker against a fall in the value of the securities to the point that the investor can no longer cover the loan.
futures contracts are settled at the end of each day (known as marking to market), profits are added and losses are deducted from this initial margin amount. When the initial margin amount is reduced to a certain level (known as the Maintenance Margin) due to losses, the broker will ask the trader to top up the margin (known as Variation Margin) back up to the initial margin amount in what is known as a margin call.
Relationship Between Initial Margin, Maintenance Margin, Margin Call and Variation Margin
Now that you had an overview of what margin is in futures trading, lets take a closer look at the different aspects of futures margin mentioned above:
Initial margin is the cash deposit required to be put forward when opening a new futures position which is determined based on a percentage of the full contract value. Opening a futures position means to go long or go short on futures contracts. Initial margin applies in futures trading no matter if you are long or short a futures position. This is unlike inoptions trading where you actually receive money instead of pay money when putting on a short options position.
Initial margin is calculated based on a percentage of the total value covered under the futures contracts. This percentage varies according to the futures market that you are trading. In single stock futures trading, the required initial margin is 20% of the value of the contract in the USA. Initial margin for more index futures and commodities futures around the world are calculated using a system known as "SPAN Margin" which may vary from day to day.
Initial Margin Example:
Assuming you go long on the futures contracts for XYZ stock trading at $10 covering 100 shares.
Total value covered under futures contract = $10 x 100 = $1000
Initial margin required = $1000 x 20% = $200
Initial margin is a deposit made. This means that it remains your money unless deducted due to losses. As all futures contracts are marked to market daily, which means that they settle their wins and losses on a daily basis in order to control risk, wins are added onto your initial margin deposit while losses are deducted from your initial margin deposit.
Initial Margin Example:
Following up on the above example, let's assume that XYZ stock rises to $10.10 at the end of the first trading day.
Total Profit = ($10.10 - $10) x 1000 = $0.10 x 1000 = $100
Margin balance = $200 + $100 = $300
As you can see in the example above, XYZ rises $0.10 on the first day of trade and the very same day, those profits on that 1000 shares are added directly onto your margin balance. Here you can see the leverage effect of futures trading as well, making a big 50% profit on your invested capital of $200 on a mere $0.10 gain on the stock. However, leverage cuts both ways. Lets see what happens when the stock falls.
So, how low can your margin balance go before your broker becomes uncomfortable? When its lower than the Maintenance Margin required of the position.
Maintenance Margin is the minimum amount of margin balance that you need to have in your account in order to keep your futures position valid. Maintenance margin is the minimum amount of money which your broker or the exchange require you to have in your account so that losses can be deducted from it. Anything lower than that increases the risk that you may not have enough money to be deductible against losses.
Maintenance margin for trading Single Stock Futures in the US market is 20% of the cash value of the futures contract. Yes, it is the same level as the initial margin. Maintenance margin requirement would vary according to the specific market you are trading in.
Once your margin balance falls below maintenance margin level, you will receive what is known as a "Margin Call" from your broker.