Margin Mechanism in Exchange Traded Derivatives

When it comes to exchange traded derivatives, one of the first things that need to be understood is the margin mechanism. Since most people that use exchange traded derivatives also use leverage, this is the procedure that they have to follow. The process may seem to be complicated. However, it is one of the wonders of risk management and allows markets as risky as derivatives markets to work relatively smoothly. This article will provide an in-depth explanation regarding the why’s and how’s of margin trading.

What is Margin Trading ?

Margin trading, at its core is a risk management procedure. Since most of the contracts pertaining to exchange traded derivatives are highly leveraged, a margin procedure is required. It allows the investor to borrow money from the market and invest this borrowed money. Even though the derivatives market is highly speculative, the safety of the principal and interest of the borrowed money is guaranteed via margin trading.

At first, the buyer i.e. the borrower puts up a small fraction of their own money. This is called an initial margin. Then, as the market prices move concepts like margin call and revaluation margin come into picture. Let’s have a closer look at them in this article.

Initial Margin

The initial margin is like a down payment on a loan. Just like when we buy a house we need to put a certain amount of money down, similarly in case of exchange traded derivatives we need to put a certain amount of money in the form of an initial margin.

Let’s say that a person wants to buy a contract worth $1000. However, they only have $100. In this case, they can begin the trade using their own $100 as initial margin and borrowing the rest of the $900 from the broker. The broker lends this money at a certain interest rate. The interest on this money is calculated on a daily basis and is calculated till the borrower returns the entire amount in full. Also, it needs to be understood that not all borrowers are allowed to lend money to buyers. There are certain approved brokers that are authorized to do so because these approved brokers in turn maintain margin accounts with the exchange. Hence, the initial margin basically acts as collateral. It can be used to offset any losses from any adverse price movements by the lender.

Variation Margin

Once the trade begins i.e. the money has been borrowed and has been invested in the contract, the buyer is then exposed to the fluctuating prices in the markets. The derivative securities are marked to market every few hours or at least once at the end of the day.

So, now let’s say that the $1000 contract that was purchase by the borrower is worth $1200. This means that $200 profit has been made by the investor. This money is instantly available in their account.

On the other hand, if the contract which was purchased for $1000 is now worth only $950, the investor is expected to pay this shortfall of $50 with immediate effect to keep holding the position.

Variation margin, therefore is, the settlement of profits or losses by the exchange’s account to the brokers account and by the brokers account to the investors account on an intraday or daily basis. This is distinctly different from the initial margin that was used as collateral.

Margin Call

When there is any adverse movement to the position of the investor i.e. price of the contract falls to $950, an immediate margin call of $50 is sent to the broker and then to the investor. The investor must pay up $50 to continue being a part of the trade. This additional $50 is called a “margin call”. It is an urgent and immediate demand for cash infusion to ensure that the initial margin is maintained at $100 and that any additional losses are paid for by the investor.

If the investor fails to pay up on time i.e. within a few minutes, the broker will simply sell out the contract on behalf of the investor even without their will and any losses will be adjusted from the initial margin which had been held as collateral.

Logic of the Margin Mechanism

The margin mechanism is basically a tiered system. Brokers maintain margin accounts with the exchange and are allowed to trade up to a certain limit. Brokers too face margin calls and are supposed to maintain initial margins. However, brokers usually do not deal on their own account. The margin calls that they receive are simply passed on to the customer.

Hence, for the exchange, they have the cushion of deposits by a known party. The same is the case with the broker. All of this forms an intricate system wherein the exchange, lenders and brokers provide services and finance the trades. However, the risks pertaining to the trades are born by the investors themselves.