Variation margin (VM) (or Mark To Market Margin) is an essential part of the derivatives market. It is the extra money that a clearinghouse member needs to deposit with the clearinghouse to meet the minimum margin requirement.
In simple words, it is one of the three types (initial and maintenance margin being the other two) of collateral that an investor needs to deposit into their trading account. Variation margin is called so because its amount varies from case to case. It is the amount that brings back the margin to the initial margin level after losses lower it to the maintenance margin level.
Such a margin payment is usually made daily and in cash. This margin flows from the party whose contract value has come down to the other party whose contract value has gone up. The formula to calculate Variation Margin is:
Variation Margin (VM) = Initial Margin – Margin Balance
Assume for a futures contract, the initial margin is $2000, and the maintenance margin is $1500. The initial margin is the margin needed to take up the trade. If the account drops to the maintenance margin level, then the trader will have to top up the account to reach the initial margin level. In our example, suppose the account drops to $1500 (maintenance margin).
Now, the investor will have to deposit $500 again to meet the initial margin requirements. This $500 is the variation margin. When the broker asks the trader for additional funds for margin requirements, it is called margin money.
The above example covers just one futures contract. In reality, there could be several contracts having different positions operating simultaneously. The broker needs to consider all the contracts when submitting funds to the clearinghouses to cover all the types of risks. The variation margin amount depends on the market conditions and the price movement during the day.
Let us consider another example:
Mr. A buys 500 share CFDs (contracts for difference) of company ABC at $4. The total transaction value is 500*4= $2000. If the initial margin is 10% and the maintenance margin is 8%, then Mr. A will have to deposit $200 with the broker. The maintenance margin, in this case, is $160.
In case the share of ABC goes down to $3.9, Mr. A will incur a loss of $50 ($0.1*500). This $50 will get subtracted from the initial margin. Mr. A’s initial margin is now $150 ($200 – $50).
Since Mr. A still holds 500 shares now at $3.9, the initial margin requirement is $195 (10% of 500*$3.9). However, the initial margin has come down to $150 (below the maintenance margin). So, Mr. A will need to deposit $45 more to carry with the trading normally.
Variation margin – When It Is Needed?
Following are the situation that triggers the call for variation margin:
- ‘Mark to market‘ losses in open positions.
- Realized losses
- A new requirement from the clearing houses
- Combination of one or more of the above three reasons
Variation margin helps with the following things:
- VM ensures that the mark-to-market losses or the movements of the futures contracts are covered.
- This margin protects those involved in a contract if there is a default by any party. It also helps to compensate for the change in the market value of a trade.
- We can also say that it helps to reduce the exposure arising from carrying high-risk positions.
- By asking for VM, clearinghouses are also able to maintain an acceptable level of risk. This allows the clearinghouse to make orderly payments to the traders or fulfill the contracts.
When You Pay Variation Margin?
In futures trading, settlement takes place on a daily basis after the close of trading. This is when the trader gets information to provide a variation margin if the margin drops below the maintenance margin level.
The trader gets the information about the VM in the form of a “Margin Call.” If a trader has sufficient cash in their futures trading account, then the amount of variation margin is deposited automatically.
If the trader is unable to pay the margin money, the broker can sell the securities in the trader’s account to meet the margin requirements. This means the broker has the authority to close all your positions to meet the margin requirements. Moreover, the broker can sell your holding in any order, even the ones that you would never want to sell. Thus, it is crucial to take the margin call seriously.
Since clearinghouses act as a guarantor for all futures contracts, the margin requirements help lower this risk. If there are no variation margin requirements for the trader, the clearinghouses could go bankrupt to cover up for the defaults. Thus, the variation margin is very important for the successful completion of a derivative contract.