Role of Margin Money in Futures Trading
In order to enter into a futures contract, the trader needs to deposit a margin with its broker, which in turn deposits this margin with the clearinghouse.
Since the clearinghouse is the counterparty in every futures contract, the margin money is required as a guarantee to protect the clearinghouse from defaults by traders.
The margin needs to be deposited for both long and short positions.
The traders are also required to settle their accounts on a daily basis, and as the futures prices change, the margin requirement also changes. There are three types of margin that one needs to understand.
Initial margin: This is the initial margin that the trader needs to deposit in order to enter into a trade. This is usually low (3-5%).
Maintenance margin: As the prices fluctuate, the margin requirements also change. The maintenance margin is the minimum amount of margin that must be maintained in the futures margin account. If the margin balance falls below this maintenance margin, the trader will receive a margin call to deposit more funds in order to bring the margin balance back to the initial margin level. For example, the initial margin could be $5,000 and maintenance margin could be $4,000 on a trade of $100,000. If the margin balance goes below $4,000 the trader will receive a margin call.
Variation margin: This refers to the amount of additional funds that need to be deposited in order to bring the margin balance back to the initial margin level. For example, if the maintenance margin is $5000 and the current margin is $3000, then the trader will receive a margin call. The variation margin will be $2000.
Both the initial and the maintenance margin requirements are set by the clearinghouse. They are calculated based on the historical daily price volatility of the underlying assets.
For the purpose of calculating the margin requirement, the settlement price is used. The settlement price is calculated as the average price during the last closing period. They do not use the closing price as the settlement price to avoid any price manipulation by the traders.