Understanding the differences between an initial margin and a maintenance margin is a key concept for anyone who decides to trade on margin. Trading on margin is not commonly done in stock trading except by professional investors and institutional traders. However, trading on margin is standard practice in the futures markets and forex (FX) trading. The ability to trade on a relatively low margin, with high leverage, is part of what attracts many speculators to futures and forex trading.
The shares of the stock serve as collateral for 100+ high dividend stocks list the loan, and investors pay interest on the amount borrowed. Once the stock has been purchased, the maintenance margin represents the amount of equity the investor must maintain in the margin account. Regulation T sets the minimum amount at 25 percent, but many brokerage firms will require a higher rate. Continuing with the same example used for the initial margin, imagine the maintenance margin is 30 percent. The value of the margin account is the same as the value of the 1,000 shares.
What is the difference between variation margin and initial margin?
MTA is usually €500k, so it means VM is not actually traded religiously every single day between counterparties. Because you always know where you stand in the trade, instead of waiting for the settlement date. The SIMM is more risk-sensitive than the grid-based approach, but also more complex. Collateral is an item of value a lender can seize from a borrower if they fail to honor their financial obligations. Access and download collection of free Templates to help power your productivity and performance.
The goal is to protect the financial institution from the potential future exposure (PFE) resulting from the default of the counterparty it is selling the derivative to. Initial margin (IM) is the collateral a counterparty pays to a bank to cover the risk it represents. The financial institution collects the amount right at the inception of the contract. When trading on margin, an investor should also consider the interest or other fees charged by their broker in order to calculate the true cost of the trade and the profit or loss potential.
What is Initial Margin?
Based on your exposure to the bank and its risk profile, after using your internal model in line with the SIMM, you arrive at the initial margin the bank should post to you. Collateralization is a widely adopted practice in the OTC derivatives market, with initial margin and variation as the two main types of collateral. Variation Margin (VM) is the collateral exchanged every day to cover the mark-to-market change of an OTC derivatives contract. Whether one model will yield savings in margin requirements over the other or not depends on the composition of the portfolio.
Initial Margin Calculation
Some securities, especially volatile ones, will have higher margin requirements set by brokerages. If a trader buys an oil contract, and then the price drops $2, the value of the contract has fallen $2,000. If the balance in the account is less than the maintenance margin, the trader must place additional funds to meet the maintenance margin. If the trader does not meet the margin call, the broker or exchange could unilaterally liquidate the position. Initial margin is collateral a firm collects/pays to reduce its future exposure to its counterparty in a non-cleared derivatives trade. On the flip side, variation margin is collateral exchanged every time one side of the trade loses too much value to reduce the exposure of the winning counterparty.
While a futures contract may have a very high value, a trader can buy or sell the contract with a much smaller amount, which is known as the initial margin. Regulators defined this model and it is top binary options courses online straightforward to implement. Once a futures trading position is established, a trader must maintain a certain balance established by the broker—typically 50% to 75% of the initial margin—to continue holding the position.
The trader must sell contracts or add assets to meet the margin within a set period of time. If a trader does not maintain the day margin, the brokerage firm can sell contracts, suspend trading privileges or both. To secure a margin loan, investors deposit cash and securities into their accounts to serve as collateral.
To better understand convert euro to turkish lira the initial margin calculation, consider the following example. IM ensures there is a margin buffer to protect against losses following the default of a counterparty. The daily exchange of VM reflects the profit or loss of each counterparty compared to the previous valuation of the financial instrument they trade. Under the grid method you determine initial margin by simply applying percentages to the notional of derivatives by product type and maturity. Let’s say you’re an asset manager looking to trade interest rate derivatives with a bank.
The cash value of these assets is the margin available for borrowing at any given time. Brokerage firms demand that the margin is kept equal to a percentage of the trader’s loan. This can vary depending on the market value of what the trader holds at any time, along with individual futures contract’s risk and volatility. Consider an investor engaged in margin trading who purchased shares worth $10,000. The investor paid a margin of $5,000 in cash and financed the balance amount of $5,000 required by borrowing from the brokerage firm.
If the price of the stock drops, the investor will be paying interest to the brokerage firm in addition to making larger losses on the investment. Regulation T governs the amount of credit that brokers and dealers can provide to investors for the purchase of securities in the United States. In the US, the initial margin is set at 50% of the purchase price of a security. With that said, brokers and dealers may require a higher margin if they deem the investor to be riskier. The value of a futures contract is derived from the cash value of the underlying asset.
- I’m happy to be able to spend my free time writing and explaining financial concepts to you.
- The authorized regulatory organization sets the minimum value required to be paid in cash to purchase margin securities.
- This scenario also adds a point to the initial margin vs. variation margin.
- One of the most appealing features of futures trading is the ability to trade big contracts with a relatively low initial investment, which is known as leverage.
- Hence the total purchasing price is $20,000, and the equity value in the margin account is $20,000.
Calculation Examples
For futures contracts, exchanges set initial margin requirements as low as 5% or 10% of the contract to be traded. For example, if a crude oil futures contract is quoted at $100,000, a futures account holder can enter a long position by posting only $5,000 initial margin, or 5% of the contract value. In other words, this initial margin requirement would give the account holder a 20x leverage factor. When a trader makes an initial futures contract purchase, the brokerage firm requires an initial margin, which is collateral equal to a percentage of the market value of the contract. The exact initial margin percentage is based on a number of factors, such as prior trading activity, current holdings, and perceived risk. Once futures contracts are purchased, the brokerage firm requires a day margin, which is the total amount of collateral based on everything held in the account from day to day.