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Initial and Variation Margin for Futures


Some thoughts and considerations with regard to Initial and Variation Margin for Futures



1) Futures Contracts

2) Initial Margin

3) Variation Margin

4) Margin Call

5) Considerations for CTRM


1) Futures Contracts


This is some background on futures contracts that is relevant to this post and is partially based on common questions.  If you know already what futures contracts are, you can skip this part.  Also, while there are futures contracts for other things besides commodities, e.g., stock indexes, interest rates, etc., we are talking only about commodity futures.


1.1) Futures contracts are cleared on an exchange.  Cleared means that the exchange becomes the counterparty of the deal.  For example, if you buy 100 futures contracts and some other person, ‘Person A’, sells 100, the counterparty on your trade is not ‘Person A’, but rather the exchange.  Even if in reality you and Person A were the only people doing trading. 


This means, for one thing, that you only have to worry about the credit risk of the exchange.  If the trade is profitable and Person A goes bankrupt, the exchange will pay you or delivery the commodity.


This is in comparison to the OTC (over the counter) market, where you buy (or sell) from one specific person (firm), and so do care about credit risk.


Note that you can trade with some other person on an exchange, e.g., you put up a bid to buy at a certain price and someone sells to you.  In this example, the trade is done on the exchange, e.g., ICE, but not cleared on the exchange.  That means your counterparty would be the other person.  i.e., ‘cleared on the exchange’ means your counterparty is the exchange.


1.2) Futures contracts are standardized.  For example, one Natural Gas futures contract, Henry Hub delivery on the NYMEX, is 10,000 MMBTU.  If you want to buy 20,000 MMBTU, that is fine, you can buy 2 contracts.  However, you can’t buy 15,000 MMBTU on the exchange.  You would need to buy that, if you want, in over the counter trading.


One contract is also called ‘one lot’, so 10,000 MMBTU/contract is called the ‘lot size’.


It is not just volumes that are standardized.  Also quality and location of delivery.


1.3) Futures contracts are an agreement today, i.e., as of the trade date, for example on 08-Jul-2019 for delivery and payment in the future.  i.e., you agree today on the quantity you’ll buy and the price.  E.g., for December 2019.  But you don’t actually pay, i.e., you don’t buy it until December.  And you don’t get the goods until December as well.


2) Initial Margin

Since the exchange is responsible for the each party meeting their obligations, i.e., the exchange will want some collateral.  This involves cash that you give the exchange to hold.  It is your money and they pay interest on it.  So long as you make good your end of the bargain, you get it back.


The money you give them to hold is called the ‘margin’, i.e., it is providing them a margin of safety against your bankruptcy or default.  When you do a trade, you must put up an initial amount, i.e., the ‘initial margin’.


The actual dollar amount varies by commodity and by exchange.  We’ll use $5,000 as an example.


3) Variation Margin


Suppose you do the trade, e.g., assume buy one futures contract, at the closing price of the day.  One contract and you put in your margin of $5,000.


The next day, the market might move slightly against you, so you lose $300.  That is OK, as the exchange still has $4,700 remaining of the money you put up as initial margin. 


The daily fluctuations are described as your daily PnL (profit/loss), i.e., the change in MTM.  For the exchange, this daily fluctuation is your variation margin. 


Though you might find a better description of the exact details of how this works on the internet, the important thing for this blog post is that for a CTRM system, a ‘variation margin’ report is the same, i.e., has the same value as a daily PnL (change in MTM) report.


4) Margin Call


In the above scenario, when you lose $300, the exchange still has the $4700 and won’t ask you for more money.  However, there is some threshold of losses where they will ask you to for more money, i.e., for more margin in your account.


We can assume for this example that the exchange requires a minimum of $3000 in margin.


So suppose the next day, the futures contract you bought goes way down such that you lose another $2000.  Leaving your margin account at the end of the day only at $2700, i.e., down $2000 from $4700.  Since that is below the $3000 minimum, the exchange will require you to put more money in.  But they won’t just want the $300 necessary to get you to the minimum margin of $3000.  They’ll want $2300 from you to get back to the $5000 initial margin level.


This is the infamous ‘margin call’ as featured as a plot point of many a Hollywood movie.


5) Considerations for CTRM


Two main things for CTRM:


5.1) First, the easy part which is the requirement of being about to produce a daily Variation Margin report.  Since this is just the same as a PnL report for futures trades, which would be needed anyway, a typical CTRM system can produce this.


5.2) Next, the hard part.  It is really hard to produce a report that shows what the Initial Margin would be.  So it is rare for any firm to make their CTRM system do this.  It is hard because the actual calculation is

a) complicated

b) different for each exchange/product/time frame

c) changes, e.g., the initial margin may go up if an exchange feels a particular commodity has become more volatility.


As a practical matter, if your broker, i.e., the one trading on your behalf on the exchange, and/or the exchange says you need to put ‘X’ into your margin account, then you need to do that, no matter what report your CTRM system might produce. 


And being a little above or below what you think the proper margin should be doesn’t matter so much since you are getting interest on the account. 


This is one of those cases where being 99% accurate in your CTRM system is the same as being 0% accurate.  If you can’t tie out exactly between the CTRM system and the broker/exchange for the margin, then you might as well not bother trying to calc the numbers on your end and just go with the numbers they give you.


It should be noted that the above isn’t meant to represent your humble bloggers opinion as to the worth or not of trying to calculate and/or reconcile initial margin amounts.  Instead, the above is mentioned to try to share thoughts why, as a practical matter, CTRM systems don’t have functionality around Initial Margin reports… even though many of them might say that they do… and why most firms don’t bother to try to get these kinds of reports out of the system.  Though variation margin reports are a different matter and super easy to get, barely an inconvenience.



Introduction to CTRM

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