The requirements for margin and daily settlement are the chief safeguards for any futures market. The main underlying principle of a margin is to supply a financial safeguard ensuring that traders will carry out their contract obligations.
As the margin requirement restricts the activity of traders, exchanges and brokers try to ensure that the margin requirements are not unreasonably high. The margin amount can vary from contract to contract and may vary by broker as well.
In 1988, the Chicago Mercantile Exchange introduced SPAN (Standard Portfolio Analysis of Risk) portfolio, margining for futures contract at both the clearing and customer level. This system has formed the basis to evaluate risk in an entire portfolio to match margin to risk that has been in use for many years in around 30 exchanges worldwide.
There are two types of margins that serve as safeguards for the futures market. A trader must deposit an amount in either cash or eligible securities before trading any futures. this initial deposit is called the initial margin. Upon suitable completion of all obligations related to the trader’s futures position, the initial margin is restored. Accrued interest is returned if a security served as the margin.
Because futures prices are volatile, each account will have frequent gains and losses. When the value of the trader’s funds on deposit with the brokerage house attains a determined level, called the maintenance margin, the trader has an obligation to replenish the margin, bringing it back to its initial level. The demand for additional money is called a margin call. The extra amount the trader must deposit is called the variation margin.
For most futures contracts, the initial margin may be 5% or less of the underlying’s value. This relatively low percentage is reasonable as the maintenance margin provides additional protection, whereby traders have to realize losses on the day that it occurs. The maintenance margin is generally about 75% of the initial margin.
Assume trader A wishes to buy one contract of Middle East Crude Oil Futures for $70. Assuming an initial margin of 5% and each contract is for 1000 barrels, the initial margin is $3500. The maintenance margin (75% of the initial margin) is $2625. If the price of Middle East Crude falls to $69.50 the next day; this represents a loss of $500 with resulting equity in the margin account equal to $3000. There is no margin call as the equity amount is more than the maintenance margin ($2625). On the following day, the price falls to $69. This represents a total loss of $1000 when the initial margin was computed. There will be a margin call as the equity amount is now $2500. The broker will now require that the trader replenish the margin account to $3500. The trader must now pay $1000 variation margin.