As per financial theories, a margin is a form of security or pledge that the owner of a position in futures contracts, options or securities has to place for the purpose of covering his counterparty’s credit risk. This kind of risk can come up if the owner has performed any one of following activities:
He has done a short selling of options or securities
He has participated in a futures contract
He has taken a loan from the counterparty for purchasing options or securities
The collateral or pledge may take the form of securities or cash and it is put into a margin account. On the futures exchanges in the United States of America, margin was officially known as performance bond. Margin buying is a process in which securities are purchased by an individual’s own money along with loan taken from a broker. This results in the amplification of any gain or loss from the securities. The securities function as pledge or collateral for the debt.
The net value or the variation between the loan and the value of the securities is equivalent to the individual’s own cash amount utilized at the initial stage. This variation is to be maintained over a minimum margin requirement. This is for the purpose of providing safeguard or protection to the broker from a decline in the security value to the extent that they are not able to compensate the loan.
In the decade of 1920s, the margin requirements were flexible in nature. Otherwise stated, the investors had to deposit minor or small amount of their own cash to the brokers. When there was a sharp fall in the stock markets, the net value of the positions dropped down under the minimum margin requirements at a fast pace and this provoked the investors in selling their positions. This is considered as a significant element, which contributed towards the Stock Market Crash in 1929 and that successively led to the Great Depression.
Margin requirements can be categorized into the following types:
Variation margin: Variation margin is also known as maintenance margin and it is not a security or pledge, but a counterbalancing process of profit and loss on a daily basis
Current liquidating margin: This refers to the value of a position in securities if the position is going to be paid off at the present time
Additional margin: The intention behind additional margin is to cover a probable decline in the position value on the succeeding day of trading
Premium margin: Here the option seller has the responsibility to render the fundamental of the option if it is practiced
The minimum margin requirement (also known as maintenance margin requirement) is the combination of all these various forms of margin requirements. The collateral or margin put into the margin account should be equivalent to the minimum.
At the time when the margin deposited into the margin account is under the minimum margin requirement, a margin call is issued by the exchange or broker.
The speculators use a term, which is known as margin-equity ratio. This denotes the trading capital amount that is retained in the form of collateral at any specified point of time.
The ROM or return on margin ratio is frequently applied for assessing the performance as it refers to the net loss or net gain in comparison to the anticipated risk of the exchange as shown in the margin requirement.
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Last Updated on : 1st July 2013