Margin (finance)
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For other uses, see margin.
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 (most often his broker). 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 U.S. futures exchanges, "margin" was formally called performance bond.
Margin buying
Margin buying is buying securities with cash borrowed from a broker, 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. 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 requirementsCurrent liquidating marginThe 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, if he is long it is the money he can raise by selling it. Variation marginThe 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 marginThe 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 marginAdditional 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 requirementThe 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.
Initial and maintenance margin requirementsThe 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 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 callWhen 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 CallsThe minimum margin requirement, sometimes called the maintenance margin requirement, is the ratio set for:
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 reduced from 60% to 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.
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 marginsMargin 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 ratioMargin-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 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 marginReturn 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
For example if a trader earns 10% on margin in two months, that would be about 77% annualized. Sometimes, Return on Margin will also take into account peripheral charges such as brokerage fees and interest paid on the sum borrowed. See alsoExternal links
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