Learn More About Contract For Difference Margin Types

Posted by fts on 08 July 2010

CFD Margin requirements
An initial margin amount is required to open a CFD position, either long or short. There are two sorts of margins which are applied to the entire value of a Contract for difference position. They are initial margin and variation margin.

Initial Margin
Initial Margin is the initial deposit needed to open a position. For Australian equity Contracts for difference, this ranges from between 5% to 50% of the total notional value of the position. Hence, if you bought 10,000 XYZ CFDs at $1.35, you would be required to have not less than $1,350 within your account to cover the minimum margin prerequisite (10% of the total position size of $13,500). The margin prerequisite for index and foreign exchange CFDs is often as low as 1%.

Variation Margin
Variation Margin relates to the difference between the initial margin and the margin needed to hold the position open as the position value changes. For example if you buy 2,000 XYZ CFDs, at $5.60 it will give you a position value of 2,000 x $5.60 = $11,200. Assuming XYZ is margined at 10% you would want at the very least $1,120 initial margin to open this position. If XYZ falls to say, $5.40, you will now have a loss of $400 ($0.20 x 2,000). This loss (known as variation margin) is subtracted from your initial margin of $1,120, leaving a deposit of $720. Since you continue to hold 2,000 XYZ contracts at $5.40 you will have a margin requirement of $1,080 (i.e. 2000 x 5.40 x 10%). There’s now a paper loss of $400 and the initial margin has been reduced to $720. This is exactly $360 less than the margin required to keep the position open, which means more margin is necessary to top up the account. The deficit in margin is known as a shortage in equity. If you cannot sustain your margin requirement you will be unable to increase your position however you will always be able to reduce or close a position.

Equity Balances
The equity (or balance) of your account will vary according to the money you have deposited or withdrawn out of your account, the profits or losses in your account and the size of the positions held. In the course of the trading day your account balance, plus all open positions, are valued against the prevailing market rate. As a result your equity balance is continually calculated in-line or marked-to-market with market movements. Your end of day account balance is calculated using the mid-closing rates (or the last traded price). The equity balance is used to evaluate your available margin against existing positions, and possible new positions you may need to take. Your cash balance is used to establish if there is a necessity for additional margin deposits on your account. Once a CFD trade is opened, variation margin requirement should always be maintained on your open positions. It’s your responsibility to ensure that your account is satisfactorily margined always, particularly during volatile trading periods. You’ll only be allowed to buy and sell and maintain open positions on the basis of cleared funds in your account, not on promised funds or funds in transit for that reason you are required to permit sufficient time for funds to clear when depositing cash into your account.

If a position turns into profit, the rise in the equity of your account allows for more positions to be opened.

Shortage in Equity
A shortage in equity takes place when the account balance falls below the specified initial margin. Accounts having a shortage in equity are usually only allowed to reduce open positions, until the equity balance is in more than the required deposit. No new positions can be opened until this situation is rectified.

Margin Calls
If the market moves against you and your equity balance falls below your initial margin you normally have the option to:
i. close a number of of your open position(s), to reduce your initial margin to the required level; and/or
ii. add more money to your account to maintain the initial margin.
This is the initial trigger level for margin, referred to as the ‘Margin Call’, which you must add additional funds to keep your open positions.

Stop Out Level
You are at risk that your open positions will generally be closed whenever you have less than 40% of your required initial margin (i.e. 40% of the position size) however this will likely vary between CFD providers.

Margin, leverage and risk
Margin plus the associated leverage can be very useful if you utilize it correctly. It can also be devastating to the inexperienced trader who has little understanding of the hazards of using leverage and not using a defined risk management strategy. There are many ways of using the leverage available by trading CFDs, from the most conservative to the most aggressive. The way in which you utilize leverage will depend upon your individual circumstances.

Before trading Contracts for difference you must read the Product Disclosure Statement (PDS) your CFD broker issues as this will explain in detail how your Contract for difference provider deals with margin. You must also read this free guide to CFD trading, which explains leverage and margin in detail.

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