Buyers and sellers of futures contracts come together at the exchange. An exchange is a transparent marketplace; there, those market participants establish fair prices based on current market conditions. The current price of a futures contract is the latest price where buyers and sellers have agreed to transact. That means futures exchanges establish transparent market prices on a real-time basis.
Success Depends on Buyers and Sellers Meeting Mutual Obligations
The success of a futures market depends on the confidence that buyers and sellers meet their mutual obligations. Each futures exchange has a clearinghouse. The clearinghouse guarantees that both parties—the buyer and the seller—perform on the contracts that they trade. In other types of transactions, a buyer purchases from a seller and each depends on the other for performance. But on a futures exchange, it is the clearinghouse that becomes the contract partner of each party to the transaction. Therefore, there is no credit risk between the buyer and seller. Each looks to the clearinghouse for performance. The exchange charges a small fee on each contract traded. This is done in order to support the administration of the clearinghouse.
What Are the Two Types of Margin?
In order to make sure of performance on each futures position, the clearinghouse requires buyers and sellers who open new positions to post margin. Margin is a good faith performance deposit. There are two types of margin: original margin and variation margin. Margin ensures that if the price moves against a buyer or seller that the party has enough money to cover those losses. Margin can be in the form of cash or negotiable and liquid securities. When a buyer or seller opens a new position on a futures contract, the party is required to post original margin. Original margin requirements are higher than variation margin requirements. The latter comes into play when the amount of original margin posted drops below the variation margin level. When this occurs, the party is required to add more margin immediately. Let’s look at an example for a buyer of one CME/COMEX gold futures contract:
Gold price is $1,180 per ounce.Each contract represents 100 ounces.Original Margin requirement: $6,600 per contract.Variation Margin requirement: $6,000 per contract.A buyer at $1180 must immediately post $6,600.If gold falls below $1,174 (a $600 loss), the buyer must add more margin.
In theory, this system ensures there will be enough resources available for buyers and sellers to meet their obligations. Futures prices can be very volatile. That means there may be more than one margin calls in a day. The futures exchange itself is responsible for setting margin requirements. When prices become more volatile, an exchange will often raise margin requirements. This is in order to account for the added risk of wider daily price ranges. On the other hand, when volatility in a certain market decreases, exchanges will adjust the amount of margin needed to trade lower to reflect the lower risk.
How Do Margin Levels Reflect Volatility?
Margin levels reflect volatility. Markets that are more volatile require more margin as a percentage of total contract value. In the gold example, the original margin required is only 5.6% of total contract value. $1,180 times 100 ounces per contract = $118,000. $6,600 ÷ $118,000= 5.6%. Therefore, a buyer or seller only has to post 5.6% of the total contract value to control a full contract of gold. Futures markets offer tremendous leverage to buyers and sellers. Of course, more volatile futures contracts will require more margin on a percentage basis. Natural gas futures currently require approximately 7% original margin. This reflects the higher volatility of natural gas prices. Clearinghouses serve as the contracting party to buyers and sellers on futures exchanges. Margin protects the clearinghouse from losses. It ensures that buyers and sellers fulfill their obligations.
Update on Margin and Clearing
Margin is at a certain level for individual futures or commodity contracts. But those who do not trade outright long or short positions will often see different margin levels against their positions. For instance, intra-commodity spreads often receive treatment that is more favorable when it comes to margins. The margins for these term structure spreads are lower than for outright long or short positions in any one month. Additionally, inter-commodity spreads often have a lower margin than the sum of the outright margin requirements for either commodity. This is because the exchanges use a SPAN system. SPAN uses a sophisticated set of algorithms that determine margin. It takes into account the total daily exposure of a trader’s portfolio rather than each specific position. Exchanges are responsible for margin levels. They can change at any time. That’s because sometimes market prices are volatile; at others, they are not. What happens when an exchange suddenly changes the margin requirement for a futures contract? It can trigger a move in the price of the market. This happened in April and May 2011. The COMEX division of the CME raised the margin on silver when it traded to highs just under $50 per ounce. The rise in margin caused some market participants to close long positions. This added to a huge downside move in the price of silver at that time. Margin is an important concept for traders to understand as it can influence prices. Margin is the mechanism that guarantees that a clearinghouse can meet obligations to all market participants.
