Initial and Variation Margin Process
Initial and Variation Margin Process
Margin is the financial safeguard that ensures futures contract performance. Initial margin is posted when entering a position; variation margin reflects daily gains and losses. Understanding these mechanics is essential for managing cash flows and avoiding forced liquidation.
Definition and Key Concepts
Initial Margin
Initial margin is the deposit required to open a futures position. It represents a performance bond—collateral held by the clearinghouse to cover potential losses from adverse price movements.
Key characteristics:
- Set by the exchange/clearinghouse based on price volatility
- Typically 3-12% of contract notional value
- Posted in cash or approved securities (T-bills)
- Returned when the position is closed (minus any losses)
Maintenance Margin
Maintenance margin is the minimum account balance that must be maintained. If the account falls below this level, a margin call is triggered.
- Usually 70-80% of initial margin
- Falling below triggers immediate requirement to restore to initial margin level
- Failure to meet margin call results in forced liquidation
Variation Margin
Variation margin is the daily settlement of gains and losses. Each day, positions are marked to market:
- Gains are credited to the margin account
- Losses are debited from the margin account
- This prevents accumulation of large unrealized losses
Margin Flow Summary
| Margin Type | When Applied | Purpose |
|---|---|---|
| Initial margin | Position opening | Performance bond |
| Maintenance margin | Ongoing threshold | Minimum balance |
| Variation margin | Daily at settlement | Realized daily P/L |
How It Works in Practice
Opening a Position
Example: Buying 1 E-mini S&P 500 futures contract (ES)
Contract details:
- S&P 500 index: 4,500 points
- Contract multiplier: $50 per point
- Notional value: 4,500 × $50 = $225,000
Margin requirements:
- Initial margin: $12,000 (5.3% of notional)
- Maintenance margin: $10,800 (90% of initial)
To open the position, the trader deposits $12,000 into the margin account.
Daily Mark-to-Market
Day 1: S&P 500 settles at 4,525 (+25 points)
Variation margin = 25 × $50 = +$1,250
| Account Component | Amount |
|---|---|
| Opening balance | $12,000 |
| Variation margin | +$1,250 |
| Closing balance | $13,250 |
The $1,250 is credited immediately—it's real cash, not paper profit.
Day 2: S&P 500 settles at 4,480 (-45 points from Day 1)
Variation margin = -45 × $50 = -$2,250
| Account Component | Amount |
|---|---|
| Opening balance | $13,250 |
| Variation margin | -$2,250 |
| Closing balance | $11,000 |
Balance is still above maintenance margin ($10,800), so no margin call.
Day 3: S&P 500 settles at 4,420 (-60 points from Day 2)
Variation margin = -60 × $50 = -$3,000
| Account Component | Amount |
|---|---|
| Opening balance | $11,000 |
| Variation margin | -$3,000 |
| Closing balance | $8,000 |
Balance ($8,000) is below maintenance margin ($10,800). Margin call issued.
Margin Call Process
When a margin call occurs:
- Notification: Broker notifies trader (typically by morning of next business day)
- Deadline: Trader must deposit funds to restore account to initial margin level
- Amount required: $12,000 - $8,000 = $4,000
- Deadline typically: By market open or within hours
If trader meets margin call: Account restored to $12,000, position remains open.
If trader fails to meet margin call: Broker liquidates the position at market price. Trader receives remaining balance (or owes additional if account goes negative).
Worked Example
Complete Margin Journey Over One Week
A trader sells 5 crude oil futures (CL) contracts.
Contract specifications:
- Contract size: 1,000 barrels
- Price quotation: $/barrel
- Tick size: $0.01 = $10/contract
- Entry price: $75.00/barrel
Margin requirements (per contract):
- Initial margin: $6,000
- Maintenance margin: $5,400
Total position requirements:
- Initial margin: $6,000 × 5 = $30,000
- Maintenance margin: $5,400 × 5 = $27,000
Week Summary:
| Day | Settlement Price | Price Change | Variation Margin | Balance | Margin Call? |
|---|---|---|---|---|---|
| Entry | $75.00 | — | — | $30,000 | No |
| Mon | $74.50 | -$0.50 | +$2,500 | $32,500 | No |
| Tue | $73.80 | -$0.70 | +$3,500 | $36,000 | No |
| Wed | $76.20 | +$2.40 | -$12,000 | $24,000 | Yes |
| Thu | $76.50 | +$0.30 | -$1,500 | $28,500* | No |
| Fri | $75.80 | -$0.70 | +$3,500 | $32,000 | No |
*After Wednesday's margin call, trader deposited $6,000 to bring balance to $30,000 before Thursday's settlement.
Key observations:
-
Short position gains when price falls: Monday and Tuesday were profitable.
-
Large adverse move triggers margin call: Wednesday's $2.40 move against the position exceeded the cushion.
-
Variation margin is real cash: The $2,500 gained on Monday could be withdrawn if desired (above initial margin).
-
Margin calls must be met promptly: Wednesday evening required action before Thursday trading.
Risks, Limitations, and Tradeoffs
Liquidity Demands
Daily settlement requires ready cash. A hedger who is ultimately correct may face margin calls during adverse moves before the position becomes profitable at hedge maturity.
Example: A farmer hedges corn by selling futures. If corn prices spike temporarily (before harvest), margin calls accumulate even though the physical corn will offset losses later.
Margin Increases
Exchanges can increase margin requirements during volatile periods—sometimes with little notice. A position that required $6,000 per contract might suddenly require $9,000 per contract.
Opportunity Cost
Cash posted as margin earns limited returns. Some clearinghouses pay interest on margin deposits, but rates are typically below market rates. Posting T-bills mitigates this.
Leverage Amplification
Low initial margin (often 5-10% of notional) creates significant leverage. A 5% margin requirement means 20:1 leverage—a 5% adverse move wipes out the entire margin deposit.
Common Pitfalls
-
Insufficient liquidity reserves: Keep excess margin beyond the minimum to avoid forced liquidation during normal volatility.
-
Ignoring intraday margin: Some brokers have higher intraday margin requirements and can issue intraday margin calls.
-
Weekend risk: Positions held over weekends face potential gap risk at Monday's open. No margin adjustment occurs until after the gap.
-
Misunderstanding maintenance margin: Falling to maintenance doesn't trigger a call—falling below maintenance does. The call restores to initial margin, not maintenance.
-
Withdrawal discipline: Excess margin can be withdrawn, but over-withdrawing leaves the account vulnerable to margin calls.
Checklist for Margin Management
- Know initial and maintenance margin for each contract
- Calculate total margin required for position size
- Maintain buffer above initial margin (20-50% recommended)
- Set alerts for balance approaching maintenance level
- Understand broker's margin call timeline and procedures
- Keep liquid reserves accessible for emergency deposits
- Monitor exchange announcements for margin changes
- Track variation margin daily for cash flow planning
- Consider using T-bills to post margin (earn some yield)
- Review leverage implied by margin percentage
Next Steps
To understand how daily settlements are recorded and their accounting implications, see Mark-to-Market Accounting Mechanics.
For context on how margin differs between exchange-traded and OTC instruments, review Forward Contracts vs. Exchange-Traded Futures.