FUTURE MARGIN PAGE RATINGS
To understand the workings of the futures market, the reader should remember that in many cases the product under consideration doesn’t physically exist. In agricultural products, such as wheat, the provider or farmer is selling bushels that may currently be in seed form. The user or miller is buying a product that they can’t claim for months. There is also an active market that permits participants to update their opinions moment to moment and, when they think it is advisable, change the position they may have. During this period of time, between the “taking down” of a position and delivery of the product, prices will change.
A simple but realistic way of comprehending a futures price is to look at the price today, add to it the applicable expenses, such as storage and interest costs—commonly known as “cost of carry”—and that should be the future contract’s price. However, we have excluded all the variables that could happen between today and delivery, such as, in the case of wheat, the size and quality of the crop coming to market when the future becomes deliverable.
As prices fluctuate, buyers and sellers are asked to deposit collateral into their accounts to protect the futures commission merchant (FCM), or whichever entity they are trading through, from loss. The amount, which is known as “initial margin,” differs from product to product, but it averages about 5 percent for most products. It is set at a fixed per contract rate. We will use dollar amounts for explanatory reasons. The amount is fixed by the futures exchange on which the product trades, and is determined by the marriage of quantity and underlying product volatility that we spoke of earlier. The amount must be large enough to protect the futures commission merchant from at least a major one-day price move, and yet not be so large as to be prohibitive to trade.
To explain this process, let’s assume that a product that sells for about $1.00 per unit today also has a contract size of 100,000 units. Over the last year, one particular day the price fluctuated $0.09, and another day it fluctuated $0.07 in a day. For the remainder of the year, it fluctuated between $0.01 and $0.03 per day with the price fluctuating around $0.01 for the majority of the days. If the initial margin was set so that all cases were covered, participants would have to deposit $9,000 per contract for a product that usually trades at a range of $3,000 per contract or less. What the futures market employs here is known as “value at risk.” The assumption would be that over 95 percent of the time an initial margin of about $5,000 per contract would be sufficient to cover the majority of daily movements. If that boundary was broken, the exchange would stop trading for that day to give member firms the ability to contact their clients, who must deposit more collateral.
Besides setting initial margin, the exchange will also set a minimum per contract equity amount that is required to be in the account at all times. When equity falls below this amount, the client must deposit more. Normal business practice dictates that the client must deposit at least the amount that is required to bring the account’s equity up to initial per contract margin. If the maintenance margin was set at $2,000 per contract, it would give the account an operating range of $3,000, which is the range the product trades in for the majority of the time.
Each day the value of the contracts in the account is adjusted to reflect the current market price. This process is called “mark to the market.” The mark is added to or subtracted from the futures equity in the account, depending on whether the position made or lost money. The adjustment is called “variation margin,” and it is what is used to honor the contract. It is most important that the terms of the contract always be honored.
Here’s an example from the buyer’s perspective:
Client Stan Tahl bought one of the above contracts at $1.00. As there are 100,000 units in the contract, Stan could become the owner of 100,000 units at a cost of $100,000 ($1.00 × 100,000 = $100,000). Regardless of what prices the “units” are trading at when the future becomes deliverable, it is going to cost Stan $100,000. Stan would deposit the $5,000 initial margin in his account and owe the FCM $95,000 to be paid when the units are delivered.
STAN TAHL’S ACCOUNT:
Long 1 Contract (100,000 units) @ $1.00
|
Initial Margin = |
$5,000 |
|
Account balance = |
$5,000 |
Let’s assume the market price of the unit rises from $1.00 to $1.02. The accounting system at Tahl’s FCM will credit Tahl’s account $2,000 ($0.02 profit in 100,000 units = $2,000).
STAN’S ACCOUNT WOULD THEN HAVE THE FOLLOWING BALANCES:
|
Initial margin = |
$5,000 |
|
Variation margin = |
+$2,000 |
|
Account balance = |
$7,000 |
If the futures became deliverable with the units still trading $1.02, the market representative for Stan’s FCM would accept the units and pay $102,000. The FCM would collect the $95,000 owed by Stan and add to it Stan’s original $5,000 for a total of $100,000 (exactly what Stan owes) plus the $2,000 variation margin, paying the representative a total of $102,000.
Let’s suppose the price of the unit dropped by $0.03 from $1.02 to $0.99. Stan’s account would be charged $3,000 and the variation margin would drop from plus $2,000 to minus $1,000.
|
Initial margin = |
$5,000 |
|
Variation margin = |
−$1,000 |
|
Account balance = |
$4,000 |
If at delivery the price was still $0.99 per unit, the market representative would receive the units and pay the deliverer $99,000, and Stan would have to pay the $95,000 still owed. The FCM would add the $95,000 to the $4,000 that is in Stan’s account for a total of $99,000. Stan still paid $100,000 ($5,000 original margin + $95,000 = $100,000) for $99,000 worth of units.
In the first case Stan paid $100,000 for units worth $102,000. In the second case, Stan paid $100,000 for units worth $99,000. He paid exactly what his contract called for.
Unlike in the stock market, it is as easy to sell (go short) a futures contract as it is to buy (go long) a contract. In the stock market, going short stock requires a margin account and the ability to borrow the stock being sold. The borrowed stock is delivered to the new buyer (the contra side to the short sale), who pays for it as any buyer would. The proceeds of the short sale (cash) are given to the stock lender as collateral against the borrowed stock. When the short sale is closed out, the short seller buys the stock in the market and it is returned to the security lender. The collateral (cash) is released to the short seller, who uses it to pay for the closeout purchase. All of this activity is processed through a broker-dealer. Any money difference is the profit or loss to the short seller.
In futures, as in other derivative products such as options, selling or going short a position is as natural as buying. Therefore a buyer of a future contract could be establishing a new open long position, adding to an existing long position, reducing a short position, or closing out a short position. Similarly, the seller of a future contract could be opening a new short position, adding to an existing short position, reducing a previous long position, or closing out the previous long position. The net effect of all this activity is reported to the clearing corporation, where the activity becomes part of “open interest” computation for that product.
As every buyer has a seller and vice versa, let’s introduce the contra party, Ms. Ann Tenna, to provide an example from the seller’s perspective. Ann is selling 100,000 units for $100,000. She must deposit $5,000 initial margin, which is the requirement per contract, set by the exchange. Upon delivery, Ann is to receive $105,000, made up of $100,000 received for the delivery of the units and her margin deposit of $5,000 returned.
STAN TAHL’S ACCOUNT
Long 1 Contract (100,000 units) @ $1.00
|
Initial margin = |
$5,000 |
|
Account balance = |
$5,000 |
Short 1 Contract (100,000 units) @ $1.00
|
Initial margin = |
$5,000 |
|
Account balance = |
$5,000 |
Let’s assume the market price of the unit rises from $1.00 to $1.02. The accounting system at Tahl’s FCM will credit Tahl’s account $2,000 ($0.02 profit in 100,000 units = $2,000). At the same time, the accounting system is charging Ann’s account the $2,000.
STAN’S ACCOUNT WOULD HAVE THE FOLLOWING BALANCES:
|
Initial margin = |
$5,000 |
|
Variation margin = |
+$2,000 |
|
Account balance = |
$7,000 |
ANN’S ACCOUNT WOULD REFLECT:
|
Initial margin = |
$5,000 |
|
Variation margin = |
−$2,000 |
|
Account balance = |
$3,000 |
If the futures became deliverable with the units still trading at $1.02, the market representative for Stan’s FCM would accept the units in the marketplace and pay $102,000. The FCM would collect the $95,000 owed by Stan and add to it Stan’s original $5,000, for a total of $100,000 (exactly what Stan owes). Afterward, the FCM would add the $2,000 variation margin and pay the representative a total of $102,000 for the 100,000 units. Ann’s market representative would deliver 100,000 units and receive $102,000. The market representative would pay Ann’s FCM $102,000. The FCM, upon delivery notification, would release to Ann the $3,000 balance remaining in her account, which when added to the $102,000 received when the units were delivered would total $105,000—exactly what she is owed. Based on the terms of the contract, Ann was to receive $100,000 and her margin deposit of $5,000 for a total of $105,000.
Let’s suppose the price of the unit dropped by $0.03 from $1.02 to $0.99. Stan’s account would be charged $3,000 and the variation margin would drop from plus $2,000 to minus $1,000. Ann’s variation margin would be credited $3,000 and would change from a minus $2,000 to a plus $1,000.
STAN’S ACCOUNT WOULD HAVE THE FOLLOWING BALANCES:
|
Initial margin = |
$5,000 |
|
Variation margin = |
−$1,000 |
|
Account balance = |
$4,000 |
ANN’S ACCOUNT WOULD REFLECT:
|
Initial margin = |
$5,000 |
|
+$1,000 |
|
|
Account balance = |
$6,000 |
If at delivery the price was still $0.99 per unit, Stan’s market representative would receive the units and pay the deliverer $99,000. Stan would still have to pay the FCM the $95,000 still owed. The FCM would add the $95,000 to the $4,000 that is in Stan’s account for a total of $99,000 and pay that to his market representative. Stan still paid $100,000 ($5,000 original margin + $95,000 = $100,000). Ann’s agent would deliver the units for $99,000. Upon notification of the delivery, the FCM would release the $6,000, which when added to the $99,000 received for the units gives Ann a total of $105,000, which is exactly what she is due.
In the prior example Stan paid $100,000 for units worth $102,000. In the second case, Stan paid $100,000 for units worth $99,000. In Ann’s case, she received $100,000 for units worth $102,000, and in the second case, Ann received $100,000 for units that were worth $99,000. Adding in the variation margin, Ann has a total of $105,000.
As stated above, the initial margin was set at $5,000 and maintenance margin was set at $2,000, giving a $3,000 spread. What would happen if the product value was to move up $.05 in a day, from $.99 to $1.04? Stan’s variation margin would change from minus $1,000 to plus $4,000, and Ann’s variation margin would change from plus $1,000 to minus $4,000.
STAN’S ACCOUNT:
|
Initial margin |
$5,000 |
|
Variation margin |
+$4,000 |
|
$9,000 |
ANN’S ACCOUNT:
|
Initial margin |
$5,000 |
|
Variation margin |
+$4,000 |
|
$1,000 |
As Ann’s account is below the $2,000 maintenance requirement, Ann would be “called” for $4,000 to bring the account back up to initial margin. With the $4,000 that Ann deposited in her account, Stan’s and Ann’s accounts have these balances:
|
Initial margin |
$5,000 |
|
Variation margin |
+$4,000 |
|
$9,000 |
|
|
Initial margin |
$9,000 |
|
Variation margin |
−$4,000 |
|
$5,000 |
You’ll notice that Ann’s account balance has now returned to initial, or standard, margin.
Let’s assume delivery occurred at $1.04. Stan would deposit the $95,000 still owed. That amount plus Stan’s initial $5,000 = $100,000 + $4,000 variation margin = $104,000. Ann’s agent delivered the units for $104,000. Ann is entitled to receive $100,000 for the units and her initial margin deposits returned ($5,000 initially + $4,000 from the call) for a total of $109,000. The 100,000 units are delivered and Ann receives $104,000 for them, plus the $5,000 balance from her account = $109,000.
Leverage, in this case, refers to the fact that Stan and Ann are depositing around 5 percent of the value of what they control. If the asset price changed by around 5 percent, one of them would double their money, and the other one would see their money gone. Let’s stay with Stan.
Stan bought 100,000 units @ $1.00 per unit and deposited the $5,000 standard margin:
|
Standard margin |
$5,000 |
|
Variation margin |
0 |
|
$5,000 |
The units rise to $1.05 each. Stan’s account is marked to the market and is credited (given) $5,000 variation margin.
|
Standard margin |
$5,000 |
|
Variation margin |
+$5,000 |
|
Balance |
$10,000 |
The variation margin in Stan’s account is enough for him to buy a second contract. His choice is to do nothing and let the variation margin serve to protect the $1.00 per contract price, or use it to buy a second contract, which would give him two contracts at $1.05. In the first case Stan has a nice cushion in case the price should fall, but he is earning or losing $1,000 per point. In the latter case, if the price falls more than 3 points, he would be on call for margin on two contracts but he is making or losing $2,000 per point.
Stan’s account is long two contracts at $1.05:
|
Standard margin |
$10,000 |
|
Variation margin |
0 |
|
$10,000 |
Let’s assume the price rises to $1.10 per contract. Stan now has $10,000 variation margin ($5,000 per contract) that he can leave alone or reinvest or buy two more contracts, which would give Stan four contracts at $1.10.
Stan’s account is long two contracts at $1.10:
|
Standard margin |
$10,000 |
|
Variation margin |
$10,000 |
|
$20,000 |
Stan uses the variation margin to acquire two additional contracts and is now long four contracts at $1.10:
|
Standard margin |
$20,000 |
|
Variation margin |
0 |
|
$20,000 |
As long as the price continues to rise, Stan can keep acquiring more contracts. He is now earning or losing $4,000 per point. If the price fell 3 points the account would be as follows:
|
Standard margin |
$20,000 |
|
Variation margin |
−$12,000 |
|
$8,000 |
$8,000/4 = $2,000 per contract, which would put Stan on call for $3,000 per contract to bring each contract back to $5,000. $3,000 × 4 = $12,000. Therefore, on the $5,000 investment Stan deposited, he has lost $12,000 up to this point. Had he stayed with his original investment, he would still have had a profit of $7,000.
$1.00 original value + $0.05 = $1.05, $1.05 + $0.05 = $1.10, $1.10 − $0.03 = $1.07 current value
If we follow the above example, where the price of the product continues to move in the position holder’s favor, it will continue to generate variation margin. As the position holder uses the variation margin to increase his position, he is changing the contract price to reflect a new level. When Stan Tahl used his variation margin to acquire a second contract, he owned two contracts at $1.05. The use of the variation margin negates the commission merchant’s or financial institution’s ability to honor the contract at the old price.
While the position is increasing through the use of the variation margin, the maintenance spread between current value and maintenance level (in the above example = 3 points) remains the same. If and when the market turns and gets to the point where a maintenance call is issued, it will be on the entire position. Using the previous example, had Stan run the one-contract position into twenty contracts through the conversion of variation margin into contract positions, while Stan was dreaming of earning $20,000 per point ($1,000 per contract), if the price for the underlying contracts fell by 3 points, Stan would be awakened from his dream to a maintenance call of $60,000 (3 points x twenty 100,000 widget contracts). Remember, this starts off as a $5,000 investment.
SPAN margin is a holistic view of the risk contained in a portfolio of futures and options on futures. In the case of an FCM that is carrying client accounts, the clearing corporation would want adequate collateral (margin) to protect the clearing corporation and its members. The relationship of options positions to futures changes as the future price changes. Options that were in the money become out of the money; options that were out of the money are now in the money. The clearing corporation is interested in what the risk of these positions is to it, and couldn’t care less about the individual accounts’ positions. That is the problem between the FCM and its traders or between the FCM and its clients. The clearing corporation must protect itself from the exposure of its member firms.
SPAN takes into account the price and the volatility of each instrument and its related options. By re-sorting the future contract positions and their overlying option positions into an arrangement that will isolate the maximum risk at different price points, the worst exposure or risk can be identified. Based on that configuration, the margin requirement will be determined. The following is a simple example of its purpose. Remember, in the real world we are working with future products and all the positioned option series using that future as an underlying product for all the clients or proprietary accounts of that entity.
Long 1 Call widgets six months strike price $1.05
Short 1 Put widgets six months strike price $1.03
Short 1 future six months future contract original cost $1.00
Short 1 Call widgets six months strike price $0.98
Long 1 Put widgets six months strike price $0.95
If the current market price of Widgets was:
$0.97 = The long call at $1.05, the short call at 98, and the long put at $.95 are all out of the money. There would be a $0.03 gain on the future contract position and the short $1.03 strike price put is in the money by $0.06. If the $1.03 short put was exercised for a loss of $0.06 ($6,000) and with the exercise against the short put, the account would now be flat the future contract with a net loss of $3,000 and three out-of-the-money options.
$1.00 = The long call at $1.05 and the long put at 95 are out of the money. The future contract is even. The short $1.03 put is in the money by $0.03 and the short $0.98 call is in the money by $0.02. If both options were exercised, the short put at $1.03 and the short call at $0.98 would cancel each other out, contract-wise, with a trading loss total of $0.05, and the account would be left with a short position of one future and two out-of-the-money option contracts. Margin would be required for the future contract and account short $5,000 ($0.05 × 100,000 widgets) loss as a result of the two exercises.
$1.04 = Both puts are out of the money, as is the 105 call. The short future contract has a .04 point loss, the $0.98 short call is in the money by 6 points. If the in-the-money call was exercised, the account would have a 6-point loss and be short two futures contracts and three out-of-the-money options.
Future member firms use SPAN margin on their professional clients’ accounts for the same reason. They too want to ensure that there is sufficient collateral in their clients’ accounts. The individual strategies of the clients, such as hedge funds or pension funds, are ignored and in their place is the worst outcome, reflecting their current position at different price points. Besides highlighting the worst-case scenario, the clearing corporation, the future member, regulators, and auditors can all run “what if” tests to see the vulnerability of the test subject at different price points. As you will see in the option section, the application of a long position can easily be synthetically made to resemble a short position and vice versa.
Some of the products that are traded have what could look like an escape valve; it’s called an “exchange for physical” (EFP). The owner of the physical property or product goes into a contract to exchange the delivery of that product to another party for a different future contract.
For example, supposing an oil importer owns a shipment of oil that is coming into port, but for whatever reason, a client of his cancels a contract. The importer does not have any place to store or hold the oil, but while it is the importer’s oil, the importer has not paid for it yet because it hasn’t been received.
The importer looks to the market to find another importer who could use that supply of oil. They negotiate a price for the exchange. The oil will be delivered to the new owner/importer. In exchange, the importer has sold to the old importer a future contract that will be delivered in the near future. The oil exporter or shipping company whose tankers are shipping this oil doesn’t really care who owns the oil as long as it gets paid.
There are some advantages that can be gained from an EFP. Suppose that in the preceding example, the individual who had the oil contract being delivered to him was also short a future contract for delivery at a different time. In other words, he had hedged his oil contract. Suppose the individual or company that had the future contract was short the physical oil. So we have two parties operating in the same market; one owned oil that was coming in at a set price and was short a future, which allowed it to know what price it could get if it delivered the oil out against the future, and another party that was short physical oil but longed contracts in the same products as a hedge against rising prices. If these two parties were to trade with each other, they would close out the position at an agreeable price to both. The owner of the oil, who does not have any place to store it, would have it delivered to the party that was short the oil. That short contract would be voided against the other party’s long contract, and both parties would walk away from the trades with a price for the oil and without any further exposure.
This is just one benefit of EFP. A second benefit is that through the direct negotiation between the parties, they know who they are dealing with. They actually know about and are choosing the counterparty, so they are not trading in the blind. While these negotiations are done in private, they are sent to the clearing corporation of exchanges, such as the CME Group, for processing and recording purposes. The CME Group offers a suite of these types of products under the heading “Exchange for Related Positions,” or EFRPs. The group includes the aforementioned exchange for physical, and also the exchange for risk and the exchange for option. All of these transactions go through the same process of a private negotiation where the trades are being reported to a clearing corporation. These products are applicable for use on foreign exchange contracts, interest rate contracts, stock index contracts, agricultural contracts, commodity index contracts, energy contracts, and metal contracts.