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 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.
Initial margin refers to the percentage of equity a margin account holder must contribute to the purchase of securities. In other words, initial margin refers to the proportion of the total market value of the securities purchased that must be paid in cash by the investor. Daniel purchased the shares of ABC Inc by investing $10,000 cash and $10,000 borrowed on margin. Hence the total purchasing price is $20,000, and the equity value in the margin account is $20,000. If the ABC Inc. stock value increased by 10% the market value of equity will rise to $22,000 download historical usd to hkd rates (adding 10% of $20,000) giving a 20% gain on original investment of $10,000 ($2000/$10,000). In this case, the investor benefitted from a bullish environment, but on the other hand, if the stock prices decline, the investor experience losses.
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.
How Do Initial Margin and Maintenance Margin Differ?
- In the CSA (part of an ISDA master agreement), variation margin means the collateral a counterparty collects to reflect the results of the daily marking-to-market of open OTC derivative contracts.
- Regulations do not allow netting the requested and the posted initial margin.
- Other important requirements are maintenance margin and variation margin.
- Brokerage firms demand that the margin is kept equal to a percentage of the trader’s loan.
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 game developer vs software developer salary 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.
If the price of the stock drops, the investor will be paying interest How to master the retirement trade 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.
Initial margin is the percentage of the purchase price of a security that must be covered by cash or collateral when using a margin account. The current initial margin requirement set by the Federal Reserve Board’s Regulation T is 50%. However, this regulation is only a minimum requirement; some equity brokerage firms may set their initial margin requirement higher.
The Difference Between Initial Margin vs. Maintenance Margin
For futures contracts, the clearinghouse sets the initial margin amount. Brokers, however, may require traders to deposit additional funds beyond the initial margin requirement in order to establish and maintain the account. In futures and forex trading, the margin requirements are much lower—as low as 1% to 5% of the traded contract value. Margins on futures contracts are typically 3% to 12% per contract. The margin posted by a trader represents a good faith deposit that the trader must keep on hand with the broker. This affords the trader a high level of leverage to greatly amplify the effect of price changes in terms of the dollar amount of gain or loss in the trader’s account.
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.
In other words, there’s a bilateral exchange (each party both posts and receives margin). J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.
Initial Margin: Definition, Minimum Requirements, Example
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.
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.
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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 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 shares of the stock serve as collateral for 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.
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.
