Margin Requirements
When a position is first taken in a futures contract, the investor must deposit a minimum dollar amount per contract as specified by the exchange. This amount, called initial margin, is required as a deposit for the contract. Individual brokerage firms are free to set margin requirements above the minimum established by the exchange. The initial margin may be in the form of an interest-bearing security such as a Treasury bill. As the price of the futures contract fluctuates each trading day, the value of the investor's equity in the position changes. The equity in a futures account is the sum of all margins posted and all daily gains less all daily losses to the account.
At the end of each trading day, the exchange determines the settlement price for the futures contract. The settlement price is different from the closing price, which many people know from the stock market and which is the price of the stock in the final trade of the day (whenever that trade occurred during the day). The settlement price by contrast is the value the exchange considers to be representative of trading at the end of the day. The representative price may in fact be the price in the day's last trade. But, if there is a flurry of trading at the end of the day, the exchange looks at all trades in the last few minutes and identifies a median or average price among those trades. The exchange uses the settlement price to mark to market the investor's position, so that any gain or loss from the position is quickly reflected in the investor's equity account.
Maintenance margin is the minimum level (specified by the exchange) to which an investor's equity position may fall as a result of an unfavorable price movement before the investor is required to deposit additional margin. The additional margin deposited is called variation margin, and it is an amount necessary to bring the equity in the account back to its initial margin level. Unlike initial margin, the variation margin must be in cash rather than an interest-bearing instrument. Any excess margin in the account may be withdrawn by the investor. If a party to a futures contract who is required to deposit variation margin fails to do so within a specified period, the exchange closes the futures position out.
Although there are initial and maintenance margin requirements for buying stock on margin, the concept of margin differs for stock and futures. When stocks are acquired on margin, the difference between the stock price and the initial margin is borrowed from the broker. The stock purchased serves as collateral for the loan, and the investor pays interest. For futures contracts, the initial margin, in effect, serves as good faith money, an indication that the investor will satisfy the obligation of the contract. Normally, no money is borrowed by the investor who takes a futures position.
To illustrate the mark-to-market procedure, let's assume the following margin requirements for the stock of Company X:
Initial margin $7 per contract
Maintenance margin $4 per contract
Assume that Chuck buys 500 contracts at a futures price of $100, and Donna sells the same number of contracts at the same futures price. The initial margin for both Chuck and Donna is $3,500, which is determined by multiplying the initial margin of $7 by the number of contracts, which is 500. Chuck and Donna must put up $3,500 in cash or Treasury bills or other acceptable collateral. At this time, $3,500 is the equity in the account. The maintenance margin for the two positions is $2,000 (the maintenance margin per contract of $4 multiplied by 500 contracts). The equity in the account may not fall below $2,000. If it does, the party whose equity falls below the maintenance margin must post additional margin, which is the variation margin. There are two things to note here. First, the variation margin must be in cash. Second, the amount of variation margin required is the amount needed to bring the equity up to the initial margin, not to the maintenance margin.
To illustrate the mark-to-market procedure, we assume the following settlement prices at the end of several trading days after the trade:
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Trading Day |
Settlement Price |
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