Margin (finance)

In finance, a margin is collateral that the holder of a position in securities, options or futures contracts has to deposit to cover the credit risk of his counterparty. 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 future 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 is formally called performance bond.

Margin buying

Margin buying is buying securities with some of one's own cash together with cash borrowed from a broker. 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 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.

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 was one important factor contributing to the Stock Market Crash of 1929, which in turn contributed to the Great Depression.

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 the security, if he is long it is the money he can raise by selling it.

Variation margin

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.

Premium margin

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.

Additional margin

Additional margin 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 an 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 Crude Sweet 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.

Margin call

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 he has deposited, or he can close out his position. He can do this by selling the securities, options or futures if he is long and by buying them back if he is short.

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 was 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 set at 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.

Reduced margins

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.

Margin-equity ratio

Margin-equity ratio 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 (finance) 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.

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