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C. Statistics |
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Initial
and Variation Margin for Futures
Some thoughts and
considerations with regard to Initial and Variation Margin for Futures
Outline
4) Margin Call
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.
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.
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.
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.
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
Click on this
link for a great introduction to CTRM software: Introduction to CTRM Software