In finance, a margin
that the holder of a position
, or futures contracts
has to deposit to cover the credit risk
of his counterparty
(most often his broker
). This risk can arise if the holder has done any of the following:
- borrowed cash from the counterparty to buy securities or options,
- sold securities or options short, or
- entered into a futures contract.
The collateral can be in the form of cash or securities, and it is deposited in a margin account. On U.S. futures exchanges, "margin" was formally called performance bond.
Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one's own cash used. This difference has to stay above a minimum margin requirement. This is to protect the broker against a fall in the value of the securities to the point that they no longer cover the loan.
Some say that in the 1920s, margin requirements were loose. In other words, brokers required investors to put in very little of their own money. When stock markets plummeted, the net value of the positions rapidly fell below the minimum margin requirements, forcing investors to sell their positions. This is cited as a factor contributing to the Stock Market Crash of 1929, which in turn contributed to the Great Depression. However, as reported in Peter Rappoport and Eugene N. White's 1994 paper Was the Crash of 1929 Expected (http://www.jstor.org/stable/2117982), all sources indicate that beginning in either late 1928 or early 1929, "margin requirements began to rise to historic new levels. The typical peak rates on brokers' loans were 40-50 percent. Brokerage houses followed suit and demanded higher margin from investors."
Types of margin requirements
Current liquidating margin
The current liquidating margin
is the value of a securities position if the position would be liquidated now. In other words, if the holder has a short position
, this is the money needed to buy back, if he is long
it is the money he can raise by selling it.
The variation margin
or maintenance margin
is not collateral, but a daily offsetting of profits and losses. Futures are marked-to-market
every day, so the current price is compared to the previous day's price. The profit or loss on the day of a position is then paid to or debited from the holder by the futures exchange
. This is possible, because the exchange is the central counterparty to all contracts, and the number of long contracts equals the number of short contracts. Certain other exchange traded derivatives, such as options on futures contracts, are marked-to-market in the same way.
The seller of an option has the obligation to deliver the underlying of the option if it is exercised. To ensure he can fulfil this obligation, he has to deposit collateral. This premium margin
is equal to the premium that he would need to pay to buy back the option and close out his position.
is intended to cover a potential fall in the value of the position on the following trading day. This is calculated as the potential loss in a worst-case scenario.
Minimum margin requirement
The minimum margin requirement
is now the sum of these different types of margin requirements. The margin
(collateral) deposited in the margin account has to be at least equal to this minimum. If the investor has many positions with the exchange, these margin requirements can simply be netted.
- Example 1
- An investor sells a call option, where the buyer has the right to buy 100 shares in Universal Widgets S.A. at 90¢. He receives an option premium of 14¢. The value of the option is 14¢, so this is the premium margin. The exchange has calculated, using historical prices, that the option value won't go above 17¢ the next day, with 99% certainty. Therefore, the additional margin requirement is set at 3¢, and the investor has to post at least 14¢ + 3¢ = 17¢ in his margin account as collateral.
- Example 2
- Futures contracts on sweet crude oil closed the day at $65. The exchange sets the additional margin requirement at $2, which the holder of a long position pays as collateral in his margin account. A day later, the futures close at $66. The exchange now pays the profit of $1 in the mark-to-market to the holder. The margin account still holds only the $2.
- Example 3
- An investor is long 50 shares in Universal Widgets Ltd, trading at 120 pence (£1.20) each. The broker sets an additional margin requirement of 20 pence per share, so £10 for the total position. The current liquidating margin is currently £60 in favour of the investor. The minimum margin requirement is now -(!)£60 + £10 = -£50. In other words, the investor can run a deficit of £50 in his margin account and still fulfil his margin obligations. This is the same as saying he can borrow up to £50 from the broker.
Initial and maintenance margin requirements
The initial margin requirement
is the amount required to be collateralized in order to open a position. Thereafter, the amount required to be kept in collateral until the position is closed is the maintenance requirement
. The maintenance requirement is the minimum amount to be collateralized in order to keep an open position. It is generally lower than the initial requirement. This allows the price to move against the margin without forcing a margin call immediately after the initial transaction. On instruments determined to be especially risky, however, the regulators, the exchange, or the broker may set the maintenance requirement higher than normal or equal to the initial requirement to reduce their exposure to the risk accepted by the trader.
When the margin posted in the margin account is below the minimum margin requirement
, the broker or exchange issues a margin call
. The investor now either has to increase the margin that they have deposited, or they can close out their position. They can do this by selling the securities, options or futures if they are long and by buying them back if they are short. If they don't do any of this the broker can sell his securities to meet the margin call.
Price of Stock for Margin Calls
The minimum margin requirement
, sometimes called the maintenance margin requirement
, is the ratio set for:
- (Stock Equity - Leveraged Dollars) to Stock Equity
- Stock Equity being the stock price * no. of stocks bought and Leveraged Dollars being the amount borrowed in the margin account.
- E.g. An investor bought 1000 shares of ABC company each priced at $50. If the initial margin requirement were 60%:
- Stock Equity: $50 * 1000 = $50,000
- Leveraged Dollars or amount borrowed: ($50 * 1000)* (1-60%) = $20,000
So the maintenance margin requirement uses the above variables to form a ratio that investors have to abide by in order to keep the account active.
The point is, let's say the minimum margin requirement is reduced from 60% to 25% - At what price would the investor be getting a margin call? Let P be the price, so 1000P in our case is the Stock Equity.
- (Stock Equity - Leveraged Dollars) divide by Stock Equity = 25%
- (1000P - $20,000)/1000P = 0.25
- (1000P - $20,000) = 250P
- P = $26.67
So if the stock price drops from $50 to $26.67, investors will be called to add additional funds to the account to make up for the loss in stock equity.
Margin requirements are reduced for positions that offset each other. For instance spread traders
who have offsetting futures contracts do not have to deposit collateral both for their short position and their long position. The exchange calculates the loss in a worst case scenario of the total position.
is a term used by speculators
, representing the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract
itself, then they would not profit from the inherent leverage
implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.
Return on margin
Return on margin
(ROM) is often used to judge performance because it represents the net gain or net loss compared to the exchange's perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The annualized ROM is equal to
- (ROM + 1)(year/trade_duration) - 1
For example if a trader earns 10% on margin in two months, that would be about 77% annualized
- (ROM +1)1/6 - 1 = 0.1 thus ROM = 1.16 - 1
Sometimes, Return on Margin will also take into account peripheral charges such as brokerage fees and interest paid on the sum borrowed.