Let’s learn more about Margins for Trading in Futures. In order to buy or sell commodities on the exchange, the user must deposit specific amount of money with the broker. This money is called the margin. Like many other regulations, the level of margin to be placed by traders is set by the exchange based on the amount of volatility and volume. Without margins place, the parties cannot enter into any contract. For most future contracts, the margin requirement in the range of 4%-15%. There are 6 types of margins applicable to futures trading in commodities are:
- Initial margin:
- The ‘initial margin’ is the amount that is required to be placed by the trader when they intend to enter a contract. This amount is meant to compensate for a potential loss that may occur in that day. Initial margin is applicable on derivatives contracts using the methods that the exchange finds feasible such as ‘Value at Risk (VaR)’, 99.95% confidence-interval VaR methodology, or any other concept.
- Exposure & Mark-to-Market Margin:
- After backtesting the results of the VaR model in commodities, the ‘exposure margin’ is levied. When a position is carried on more a number of days, the exchange also requires the traders to pay mark-to-market margin which are positions restated at the ‘daily settlement prices’ (DSP). After every trading session, the margin account of each user is adjusted to reflect the trader’s gain or loss. This is done to reduce credit exposure on that day’s market activities. In the case of a profit, funds are added to a trader’s account, but if a loss has occurred and the account has fallen below the initial margin, the account must be replenished by the clearing member.
- Additional margin:
- ‘Additional margin’ is called forth on occasional situations where there has been unexpected volatility in the market. To prevent potential default, the exchange necessitates this so that the system/exchange does not lose its stability in unfavorable situations.
- Pre-expiry margin:
- This ‘pre-expiry’ margin is charged by the exchange on a cumulative basis over 3-5 days near the contract expiry to ensure better convergence of the futures and spot market prices by having only interested parties remain in the market while the speculators roll over their positions to subsequent months.
- Delivery Margin:
- When a trader wants to settle the contract by taking delivery of the commodity, this margin is charged.
- Special Margin :
- Special margin is usually imposed by an exchange on certain commodities as a surveillance measure during times when there is more than 20% price movement in the same direction from a pre-determined base (underlying spot price). This base can be either, the closing price on the launch day of the contract or the 90 days prior settlement price. It is be levied by market regulators when there is excess volatility in the market.
- Margin for Calendar Spread positions:
- As mentioned before, a spread is going long on one commodity futures month while simultaneously shorting the same commodity of another contract month. At exchanges such as the NCDEX, a ‘margin for calendar spread’ is charged for such positions. Such benefits are given subject to the positive correlation in the prices of the contract months and the far month contracts’ liquidity.
