Margin (finance)
Encyclopedia
In finance
, a margin is collateral
that the holder of a financial instrument has to deposit to cover some or all of the credit risk
of their counterparty
(most often their broker
or an exchange
). This risk can arise if the holder has done any of the following:
The collateral can be in the form of cash or securities, and it is deposited in a margin account. On United States futures exchange
s, "margin" was formerly called performance bond
. Most of the exchanges today use SPAN
(Standard Portfolio Analysis of Risk) methodology for calculation of margin in 'Options' and 'Futures'. SPAN was developed by the Chicago Mercantile Exchange
in 1988.
, 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, the purpose of which is to protect the broker against a fall in the value of the securities to the point that the investor can 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. Whereas today, the Federal Reserve's margin requirement (under Regulation T
) limits debt to 50 percent, during the 1920s leverage rates
of up to 90 percent debt were not uncommon. When the stock market
started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. This was one of the major contributing factors which led to the Stock Market Crash of 1929, which in turn contributed to the Great Depression
, a troubling financial time in the 1930s. However, as reported in Peter Rappoport and Eugene N. White's 1994 paper Was the Crash of 1929 Expected, 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."
, it is the money they can raise by selling it.
The variation margin or maintenance margin is not collateral, but a daily payment 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 they can fulfill this obligation, they have to deposit collateral. This premium margin is equal to the premium that they would need to pay to buy back the option and close out their position.
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.
SMA
and Portfolio margin
offer alternative rules for US and NYSE regulatory margin requirements.
Enhanced leverage is a strategy offered by some brokers that provides 4:1 or 6:1+ leverage. This requires maintaining two sets of accounts, long and short.
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 her 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.
of selling which will lead to other margin calls and so forth... Effectively crashing an asset class or group of asset classes.
This situation most frequently happens as a result of an adverse change in the market value of the leveraged asset or contract. It could also happen when the margin requirement is raised, either due to increased volatility or due to legislation. In extreme cases, certain securities may cease to qualify for margin trading; in such a case, the brokerage will require the trader to either fully fund their position, or to liquidate it.
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 maintenance margin requirement is 25% - That means the customer has to maintain Net Value equal to 25% of the total stock equity. That means they have to maintain net equity of $50,000 * 0.25 = $12,500. So 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.
So if the stock price drops from $50 to $26.66, investors will be called to add additional funds to the account to make up for the loss in stock equity.
An alternative formula for calculating P is P=P_0((1-initial margin requirement)/(1-maintenance margin requirement)) where P_0 is the initial price of the stock. Let's use the same information to demonstrate this:
has reduced risk since any loss on the call is offset by a gain in the stock, and a large loss in the stock is offset by a gain on the put; in general, covered calls have less strict requirements than naked call writing.
implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.
For example if a trader earns 10% on margin in two months, that would be about 77% annualized
that is, Annualized ROM = 1.16 - 1 = 77%
Sometimes, return on margin will also take into account peripheral charges such as brokerage fees and interest paid on the sum borrowed. The margin interest rate is usually based on the Broker's call
.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a margin is collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
that the holder of a financial instrument has to deposit to cover some or all of the credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
of their counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
(most often their broker
Broker
A broker is a party that arranges transactions between a buyer and a seller, and gets a commission when the deal is executed. A broker who also acts as a seller or as a buyer becomes a principal party to the deal...
or an exchange
Exchange (organized market)
An exchange is a highly organized market where tradable securities, commodities, foreign exchange, futures, and options contracts are sold and bought.-Description:...
). This risk can arise if the holder has done any of the following:
- borrowed cash from the counterparty to buy financial instruments,
- sold financial instruments short, or
- entered into a derivativeDerivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
contract.
The collateral can be in the form of cash or securities, and it is deposited in a margin account. On United States futures exchange
Futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...
s, "margin" was formerly called performance bond
Performance bond
A performance bond is a surety bond issued by an insurance company or a bank to guarantee satisfactory completion of a project by a contractor.A job requiring a payment & performance bond will usually require a bid bond, to bid the job...
. Most of the exchanges today use SPAN
CME SPAN
The Standard Portfolio Analysis of Risk, or SPAN, is a system for calculating margin requirements for futures and options on futures. It was developed and implemented by the Chicago Mercantile Exchange in 1988....
(Standard Portfolio Analysis of Risk) methodology for calculation of margin in 'Options' and 'Futures'. SPAN was developed by the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
in 1988.
Margin buying
Margin buying is buying securities with cash borrowed from a brokerSecurities lending
In finance, securities lending or stock lending refers to the lending of securities by one party to another. The terms of the loan will be governed by a "Securities Lending Agreement", which requires that the borrower provides the lender with collateral, in the form of cash, government securities,...
, 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, the purpose of which is to protect the broker against a fall in the value of the securities to the point that the investor can 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. Whereas today, the Federal Reserve's margin requirement (under Regulation T
Regulation T
Federal Reserve Board Regulation T is 12 CFR §220 - Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 ....
) limits debt to 50 percent, during the 1920s leverage rates
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
of up to 90 percent debt were not uncommon. When the stock market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. This was one of the major contributing factors which led to the Stock Market Crash of 1929, which in turn contributed to the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
, a troubling financial time in the 1930s. However, as reported in Peter Rappoport and Eugene N. White's 1994 paper Was the Crash of 1929 Expected, 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
The current liquidating margin is the value of a securities position if the position were liquidated now. In other words, if the holder has a short position, this is the money needed to buy back; if they are longLong (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
, it is the money they can raise by selling it.
The variation margin or maintenance margin is not collateral, but a daily payment of profits and losses. Futures are marked-to-market
Mark to market
Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value...
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
Futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...
. 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 they can fulfill this obligation, they have to deposit collateral. This premium margin is equal to the premium that they would need to pay to buy back the option and close out their position.
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.
SMA
Special Memorandum Account
SMA is a margin credit account used for calculating US Regulation T requirements on brokerage accounts. In addition to Initial Margin and Maintenance Margin requirements, the SMA ledger is used to lock in unrealized gains that augment the clients buying power....
and Portfolio margin
Portfolio margin
Portfolio margin is a risk-based margin policy. Portfolio margin usually results in significantly lower margin requirements on hedged positions than under traditional rules...
offer alternative rules for US and NYSE regulatory margin requirements.
Enhanced leverage is a strategy offered by some brokers that provides 4:1 or 6:1+ leverage. This requires maintaining two sets of accounts, long and short.
Example 1: An investor sells a call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
, 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
Sweet crude oil
Sweet crude oil is a type of petroleum. Petroleum is considered "sweet" if it contains less than 0.5% sulfur, compared to a higher level of sulfur in sour crude oil. Sweet crude oil contains small amounts of hydrogen sulfide and carbon dioxide. High quality, low sulfur crude oil is commonly used...
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 her 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.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 investors now either have to increase the margin that they have deposited or 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. But if they do none of these, then the broker can sell their securities to meet the margin call. If a margin call occurs unexpectedly, it can cause a domino effectDomino effect
The domino effect is a chain reaction that occurs when a small change causes a similar change nearby, which then will cause another similar change, and so on in linear sequence. The term is best known as a mechanical effect, and is used as an analogy to a falling row of dominoes...
of selling which will lead to other margin calls and so forth... Effectively crashing an asset class or group of asset classes.
This situation most frequently happens as a result of an adverse change in the market value of the leveraged asset or contract. It could also happen when the margin requirement is raised, either due to increased volatility or due to legislation. In extreme cases, certain securities may cease to qualify for margin trading; in such a case, the brokerage will require the trader to either fully fund their position, or to liquidate it.
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)* (100%-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 maintenance margin requirement is 25% - That means the customer has to maintain Net Value equal to 25% of the total stock equity. That means they have to maintain net equity of $50,000 * 0.25 = $12,500. So 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.
- (Current Market Value - Amount Borrowed) / Current Market Value = 25%
- (1000P - 20000)/1000P = 0.25
- (1000P - 20000)= 250P
- 750P = $20,000
- P = $20,000/750 = $26.66 / share
So if the stock price drops from $50 to $26.66, investors will be called to add additional funds to the account to make up for the loss in stock equity.
An alternative formula for calculating P is P=P_0((1-initial margin requirement)/(1-maintenance margin requirement)) where P_0 is the initial price of the stock. Let's use the same information to demonstrate this:
- P=$50*((1-.6)/(1-.25))
- P=$26.66
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. Similarly an investor who creates a collarCollar (finance)
In finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range.-Structure:A collar is created by an investor being:* Long the underlying...
has reduced risk since any loss on the call is offset by a gain in the stock, and a large loss in the stock is offset by a gain on the put; in general, covered calls have less strict requirements than naked call writing.
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 leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
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)(1/trade duration in years) - 1
For example if a trader earns 10% on margin in two months, that would be about 77% annualized
- Annualized ROM = (ROM +1)1/(2/12) - 1
that is, Annualized ROM = 1.16 - 1 = 77%
Sometimes, return on margin will also take into account peripheral charges such as brokerage fees and interest paid on the sum borrowed. The margin interest rate is usually based on the Broker's call
Broker's call
Broker's call, also known as the Call loan rate, is the interest rate relative to which margin loans are quoted. Individuals may borrow on margin a part of the funds they use to buy their securities from their broker...
.
See also
- Collateral managementCollateral ManagementCollateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards,...
- Leverage (finance)Leverage (finance)In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
- LIBOR
- Portfolio marginPortfolio marginPortfolio margin is a risk-based margin policy. Portfolio margin usually results in significantly lower margin requirements on hedged positions than under traditional rules...
- Repurchase agreementRepurchase agreementA repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
- Special memorandum accountSpecial Memorandum AccountSMA is a margin credit account used for calculating US Regulation T requirements on brokerage accounts. In addition to Initial Margin and Maintenance Margin requirements, the SMA ledger is used to lock in unrealized gains that augment the clients buying power....