18.11 Margins for trading in futures
Margin is the deposit money that needs to be paid to buy or sell each contract. The margin required for a futures contract is better described as performance bond or good faith money. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. The margin requirements for most futures contracts range from 2% to 15% of the value of the contract.
In the futures market, there are different types of margins that a trader has to maintain. At this stage, we look at the types of margins as they apply on most futures exchanges.
The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. This margin is meant to cover the largest potential loss in one day. The margin is a mandatory requirement for parties who are entering into the contract.
A trader is entitled to withdraw any balance in the margin account in excess of the initial margin. To ensure that the balance in the margin account never becomes negative, a maintenance margin, which is somewhat lower than the initial margin, is set. If the balance in the margin account falls below the maintenance margin, the trader receives a margin call and is requested to deposit extra funds to bring it to the initial margin level within a very short period of time. The extra funds deposited are known as a variation margin. If the trader does not provide the variation margin, the broker closes out the position by offsetting the contract.
In case of sudden higher than expected volatility, the exchange calls for an additional margin, which is a pre-emptive move to prevent breakdown. This is imposed when the exchange fears that the markets have become too volatile and may result in a payments crisis, etc.
Mark-to-Market Margin (MTM):
At the end of each trading day, the margin account is adjusted to reflect the trader’s gain or loss. This is known as marking to market the account of each trader. All futures contracts are settled daily reducing the credit exposure to one day’s movement. Based on the settlement price, the value of all positions is marked-to-market each day after the official close. i.e. the accounts are either debited or credited based on how well the positions fared in that day’s trading session. If the account falls below the maintenance margin level, the trader needs to replenish the account by giving additional funds. On the other hand, if the position generates a gain, the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades.
Just as a trader is required to maintain a margin account with a broker, a clearing house member is required to maintain a margin account with the clearing house. This is known as clearing margin. In the case of clearing house member, there is only an original margin and no maintenance margin.
Finally, the futures market is a zero sum game i.e. the total number of long in any contract always equals the total number of short in any contract. The total number of outstanding contracts (long/short) at any point in time is called the Open interest. This Open interest figure is a good indicator of the liquidity in every contract. Based on studies carried out in international exchanges, it is found that open interest is maximum in near month expiry contracts.