Margins in the Derivatives Market

Derivatives_Novice_Notes_Week13: Margins in the Derivatives Market

The concept of margin applies to a wide range of derivative instruments. Margins are used to manage risk and ensure that parties in derivative contracts have sufficient collateral to cover potential losses. In short, margins are charged to prevent the Risk of Default.

In the F&O market, many traders are drawn to derivatives because of their leverage. Leverage allows traders to commit a smaller amount of capital to control the value of a large asset. Smaller changes in the underlying asset can translate into larger gains or losses. In F&O this leverage is made possible by trading on Margins.

Margin is the amount of funds required to enter a Futures contract, usually a fraction (3-12%) of the entire contract value. Margin is divided into Span and exposure components. While the broker terminal/platform displays a single margin, the margin is divided into these two components in the backend.

• SPAN (Standard Portfolio Analysis of Risk) Margin: SPAN Margin is a risk-based margining used by many exchanges to calculate margin requirements for portfolios of derivatives by assessing various risk factors and scenarios.
• Exposure Margin: refers to the static margin required based on the total risk of a trader’s entire portfolio, ensuring that there is sufficient collateral to cover potential losses from large or volatile positions.

The margin fluctuates depending on the volatility of the asset. High volatility increases the risk, leading to an upward movement in the margin. Conversely, during stable market conditions, the margin remains consistent.

Various types of Margins can be

• Initial Margin
• Maintenance Margin
• Mark-to-Market (MTM) Margin
• Variation margin
• Collateral Margin
• Portfolio Margin
• Premium Margin

Initial Margin

The initial margin is the amount of money required to open a position in a derivatives contract. it’s the percentage of the total trade value (Notional Value) that traders must provide upfront as collateral to initiate a position. The initial margin acts as a security deposit to cover potential losses that might arise from the position.

Maintenance Margin

The maintenance margin is the minimum amount of funds that must be maintained in a trader's account to keep an open position. It is typically lower than the initial margin and acts as a buffer against potential losses.

Mark-to-Market (MTM) Margin

MTM margin refers to the process of adjusting the margin account daily based on the current market value of the derivatives positions. This involves recalculating the value of positions to reflect their current market prices. It ensures that the margin account accurately reflects the current value of the positions held.

?If the market value of an asset in a contract changes, the mark-to-market margin will adjust the trader’s account balance accordingly. If the value of the contract rises, the trader’s account will be credited with the gain. If it falls, the account will be debited with the loss.

Variation margin

Variation Margin represents the daily adjustment to a trader’s margin account based on changes in the value of the position. It is essentially the cash flow resulting from the MTM process. Variation margin ensures that traders have enough funds in their margin accounts to cover the daily fluctuations in the market value of their positions. It helps to cover potential losses or realize gains due to market movement.

Example: Let us say the price of the crude oil futures contract increases, resulting in a profit of $1,000 for the trader. The variation margin will credit the trader’s account with this $1,000 profit. Conversely, if the price decreases and the trader incurs a loss of $800, the variation margin will debit the account by this amount.

Variation Margin and Mark-to-Market (MTM) Margin are terms often used interchangeably in the context of derivatives; however, they have distinct meanings MTM Margin refers to the daily valuation process of positions and the corresponding adjustments in the margin account whereas Variation Margin is the actual cash flows (payables or receivables) resulting from the MTM adjustments.

Collateral Margin

Collateral margin refers to the assets or funds posted as collateral to cover margin requirements, including initial and variation margins. This may be needed to cover specific risks or support high-risk positions. For example, if a trader is trading complex options strategies that involve significant risk, the broker may require the trader to pledge additional collateral, such as stocks or bonds, to cover potential losses. Collateral Margin can include cash, securities, or other financial instruments that the broker accepts as collateral.

Portfolio Margin

It provides a margin requirement based on the combined risk of the portfolio, potentially lowering the margin needed due to the offsetting nature of the positions. This approach allows for more efficient use of capital as it is more flexible, enabling reduced margin requirements for effectively hedged portfolios.

Premium Margin

In options trading, the premium margin is the amount needed to cover the cost of purchasing the options contract. This margin is distinct from other margins as it directly represents the price of the option itself.

?Let us understand Margins using a trading scenario.

Consider a scenario where JP Morgan is the Broker; Trader A (buyer) and Trader B(seller) enter into an S&P 500 Index futures contract with a Notional of $140,000.

As we know the initial and maintenance margins in a contract must be the same for a buyer and a seller, The Initial Margin is $5500 for both Trader A and Trader B and the maintenance margin is $5000 for both parties.

Day1: S&P 500 Index futures contract falls by 5 points

Contract Details:

• Notional Value: $140,000
• Initial Margin: $5,500 (for both Trader A and Trader B)
• Maintenance Margin: $5,000 (for both Trader A and Trader B)
• Contract Type: S&P 500 Index futures contract
• Point Value: Each point in the S&P 500 Index contract is worth $50(Assumption)

Calculation of MTM Loss

The MTM loss for a decrease of 5 points is calculated as follows:

• MTM Loss = Fall in Points × Point Value
• MTM Loss = 5 points × $50/point
• MTM Loss = $250

Trader A bought the contract, they will experience a loss, while Trader B, who sold the contract, will gain $250.

Margin Accounts details

Trader A (Buyer)

• Initial Margin: $5,500
• MTM Loss: $250
• New Margin Balance: $5,500 - $250 = $5,250

Trader B (Seller)

• Initial Margin: $5,500
• MTM Gain: $250
• New Margin Balance: $5,500 + $250 = $5,750

Maintenance Margin Assessment

Trader A

• New Margin Balance: $5,250
• Maintenance Margin Requirement: $5,000
• Status: Trader A’s balance is above the maintenance margin level, so no additional funds are required.

Trader B

• New Margin Balance: $5,750
• Maintenance Margin Requirement: $5,000
• Status: Trader B’s balance is well above the maintenance margin level.

Day2: Let us say that Next day S&P 500 fell by 10 points

Calculation of MTM Loss

The MTM loss for a decrease of 10 points is:

• MTM Loss = Fall in Points × Point Value
• MTM Loss = 10 points × $50/point
• MTM Loss = $500

Since Trader A bought the contract, they will experience a loss, while Trader B, who sold the contract, will gain $500.

Margin Accounts details:

Trader A (Buyer)

• Previous Margin Balance (End of Day 1): $5,250
• MTM Loss on Day 2: $500
• New Margin Balance: $5,250 - $500 = $4,750

Trader B (Seller)

• Previous Margin Balance (End of Day 1): $5,750
• MTM Gain on Day 2: $500
• New Margin Balance: $5,750 + $500 = $6,250

Maintenance Margin Assessment

Trader A

• New Margin Balance: $4,750
• Maintenance Margin Requirement: $5,000
• Status: Trader A’s margin balance is now below the maintenance margin requirement.

Trader B

• New Margin Balance: $6,250
• Maintenance Margin Requirement: $5,000
• Status: Trader B’s margin balance exceeds the maintenance margin requirement.

Next Steps for Trader A

Trader A's margin balance of $4,750 is below the maintenance margin of $5,000, so a margin call is triggered. Trader A will have 2 options.

• Option 1: Deposit Additional Funds: Trader A needs to deposit additional funds into their margin account to bring it back to at least the initial margin level of $5,500 or more, depending on the broker’s requirements. In this case, Trader A needs to deposit at least $250 to meet the maintenance margin requirement, but typically, the broker might require bringing the account up to the initial margin level.
• Option 2: Review and Adjust Positions: Trader A can also choose to square off their positions or liquidate some holdings to bring their margin balance back above the maintenance margin.

Day3: On the following day, the S&P 500 Index goes up by 20 points

Considering similar calculations as of Day1 & Day2

• MTM Gain/Loss = 20 points × $50/point = $1000

Since Trader A bought the contract, they will experience a gain of $1000, while Trader B, who sold the contract, will loss $1000.

Note: this is just for understanding the concept. In most cases, a trader cannot open new positions when there is an active margin call. Brokers typically restrict trading to prevent further losses until the margin call is resolved.

Margin Accounts details:

?Trader A (Buyer)

• Previous Margin Balance (End of Day 2): $4,750
• MTM Gain on Day 3: $1000
• New Margin Balance: $4,750 + $1000 = $5,750

Trader B (Seller)

• Previous Margin Balance (End of Day 2): $6,250
• MTM Loss on Day 3: $1000
• New Margin Balance: $6,250 - $1000 = $5,250

Maintenance Margin Assessment

Trader A

• New Margin Balance: $5,750
• Maintenance Margin Requirement: $5,000
• Status: Trader A’s margin balance is now above the maintenance margin requirement.

Trader B

• New Margin Balance: $5,250
• Maintenance Margin Requirement: $5,000
• Status: Trader B’s margin balance also exceeds the maintenance margin requirement.

Below are the margin balances for 3 days of trade activities mentioned above. The calculation is Mark-to-Market.

Actions Taken by Broker when Margin Call is not Fulfilled:

If Trader A does not add additional funds to restore its margin balance, the broker will take several actions to manage the risk associated with the insufficient margin. What could be the next actions by the Broker?

• ?Issuance of a Margin Call: The broker will issue a formal margin call, demanding that Trader A deposit additional funds to bring their margin balance up to the required level. This is to inform the trader that their account balance is below the maintenance margin requirement.
• Deadline for Margin Call (Time Frame): The broker will usually provide a specific deadline for Trader A to meet the margin call. This deadline could range from a few hours to a full trading day, depending on the broker's policies and the severity of the margin shortfall.
• Liquidation of Positions/Auto Liquidation: If Trader A fails to respond to the margin call by depositing the required funds, the broker will take action to protect themselves from potential losses. This typically involves automatically liquidating some or all of Trader A’s positions i.e. sell off sufficient portions of Trader A’s positions to raise the account balance to at least the maintenance margin requirement.
• Forced Liquidation: If the margin balance remains insufficient even after partial liquidation, the broker may continue to liquidate positions until the account balance meets the necessary margin requirements. This action is typically done without consulting the trader.
• Potential Additional Charges: Fees and Penalties: In addition to the loss from liquidation, Trader A may incur additional fees or penalties imposed by the broker.
• Account Restrictions: The broker may place restrictions on Trader A’s account, such as limiting the ability to open new positions or requiring the account to be reviewed before it can be reactivated fully.

That is all on Margins, stay tuned for the next article...!