Margin Requirement

The Margin Requirement is the minimum amount that a customer must deposit, and it is commonly expressed as a percent of the current market value. The Margin deposit can be greater than or equal to the margin requirement.

Margin is the money deposited by an investor with the broker when the investor enters into future contracts.

The purpose is to provide financial security for ensuring that the investors will perform the contract obligations.

Both the investors, i.e., short position and long position holders, have to deposit margin money. The quantum of margin differs from the contract and from broker to broker.

Usually, the exchange sets the minimum margin limit, but brokers may charge their clients (investors) in excess, depending on the financial condition of investors.

An essential feature of the futures contract is the marking-to-market process inherent in the margin system.

The amount of margin deposited represents a “good faith deposit” that ensures a party to the futures contract meets his obligations.

The margin deposit is not an investment in a commodity position. All that has been transacted is an agreement to buy or sell a given amount of the commodity at a future date for a prespecified price.

This is decidedly different than margins for equity, where the deposit is in partial payment for securities purchased in the cash market.

Margin deposits for futures are only required to ensure the sanctity of the contract in the face of fluctuations in its value.

Given this, it is understandable that there are different types of margin requirements depending on the individual’s position in the exchange process.

Margin Account

In margin accounts, investors either borrow some money to buy securities or borrow the securities themselves. As a result, margin accounts come in two varieties: long and short.

1. Long Margin Account: Long means to buy, with a long margin account, the customer buys securities by coming up with a certain percentage of the purchase price of the securities and borrowing the balance from the broker-dealer.

These optimistic investors are hoping for a bull market because they want to sell the securities sometime later for a profit.

2. Short Margin Account: In a short margin account, an investor in borrowing securities is to immediately sell in the market. The process sounds a bit backward, but the investor is selling things.

When a customer buys securities, he or she can purchase the securities in a cash or margin account, but when a customer sells short securities, the transaction must be executed in a margin account.

The margin, consisting of cash or cash equivalents, is to ensure that traders will honor the obligations arising out of the futures contract.

The margin has to be posted by both parties to the futures contract as both are exposed to losses.

If one incurs sustained losses from daily marking-to-market, the margin amount may fall below a critical level called the maintenance, or variation, a margin which may be around 5 percent – it too is fixed by the exchange.

Example 1: Margin for the cashew contract is 5%, and a contract to buy five cashew futures is cleared through a clearinghouse member at a price of ₹5,600 per carton. The contract size is 50 cartons.

Solution:

Value per Contract = Futures Price per Carton x Number of Cartons = 5,600 x 50 = ₹2,80,000

Total Value of Five Contracts = Value per Contract x Number of Contracts = 2,80,000 x 5 = ₹14,00,000

Margin Amount = Total Value of the Five Contracts x Margin Percentage = 14,00,000 x 5% = ₹70,000

A margin amount of ₹70,000 will have to be provided by the CM to the clearinghouse.

Type of Margins

The various types of margins are as follows:

1. Clearing Margin: These are financial safeguards to ensure that companies or corporations perform on their customers’ open futures and options contracts.

Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.

2. Customer Margin: Within the futures industry, financial guarantees are required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations.

Futures commission merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk, and contract value, also referred to as performance bond margin.

3. Initial Margin: This is the equity required to initiate a futures position. This is a type of performance bond.

The maximum exposure is not limited to the amount of the initial margin; however, the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. The initial margin is set by the exchange.

4. Maintenance Margin: A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.

5. Margin-Equity Ratio: This is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time—the low margin requirements of futures results in substantial leverage of the investment.

However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher but may not set it lower.

A trader, of course, can set it above that if he does not want to be subject to margin calls.

6. Performance Bond Margin: The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure the performance of the term of the contract.

Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

7. Return on Margin (ROM): This is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in the required margin.

ROM may be calculated (realized return)/(initial margin). The Annualised ROM is equal to (ROM + i)(year/trade_duratlon)-1. For example, if a trader earns 10% on margin in two months, that would be about 77% annualized.

Example 2: An investor buys 5 futures contracts on gold at MCX of India. Each contract is for 100gm of gold. The price quotation is ₹15,550 per 10gm. The tick size is ₹1.

The initial margin is set at 4%, while the minimum margin is 90% of the initial margin. Find out the following:

  1. What is the minimum change in the value of a contract?
  2. What is the amount of initial margin the investor has to deposit with I the exchange?
  3. At what price level the investor would get the margin call?
  4. If the investor had sold the contract, what price level would trigger a margin call?

Solution:

1. The minimum change in the price quotation is ₹1 per 10gm. The contract size is 100gm. Therefore, the minimum change in the value of the contract would be 1×100/10 = ₹10.

2. Initial Margin = Value of Contract x Margin % x No. of Contracts

=100/10 x 15,550×4% x 5 = ₹31,100

3. Minimum margin is 90% of the initial margin. Therefore, till a 10% loss, the investor would not get the margin call.

When the price falls to 90% of the initial position, the investor will get the margin call. The price must go below 0.90 x 15,550 = ₹13,995 for margin call.

4. For the initial short position, the 10% loss would be a price level that is 10% higher than the initial position. For short position the price must go above 1.10 x 15,550 = ₹17,105 for margin call.

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