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When asking most traders this question, the common assumption is ‘a large increase in margin.’
However, the impact of market moves on margin depends upon the type of margin; Initial Margin or Variation Margin. Each are impacted by large market moves differently.
Almost all ETD CCPs use the SPAN (or a SPAN like) methodology for margin calculations. The one exception to this is Eurex that has switched to use a VaR based methodology.
VARIATION MARGIN EXPLAINED
Variation Margin is all about getting profit and loss up to date. For some products it is paid in cash, whereas for others (in particular premium paid up front options) it is a contingent amount. If Contingent Variation Margin is a debit (i.e. the market has moved against you) then collateral must be provided to cover this theoretical loss, but if the margin is a credit then it can be used to offset any Initial Margin that may be required.
INITIAL MARGIN EXPLAINED
Initial Margin is a confusing name. For some types of trades it is just an “initial” amount of collateral that needs to be provided before you can trade, which is then held over the lifetime of the trade to cover the market risk. This is the description you tend to be provided if you Google “Initial Margin”.
However, this isn’t normally how Initial Margin is calculated. The purpose of Initial Margin is to ensure that the CCP has sufficient funds to close out any positions it may inherit following a default. On the assumption that the Variation Margin has been collected, the Initial Margin would need to cover any adverse market moves in the expected close out period. For Exchange Traded Derivatives (ETD), this is normally 2 days.
The Initial Margin algorithms employed by all the CCPs are portfolio based, meaning that hey look at all the positions and calculate a margin requirement for the total portfolio, taking into account offsets between different contracts and products. These algorithms are either scenario based (like SPAN) or VaR based (like Eurex Prisma).
WHAT AFFECTS THE MARGIN CALL?
Assume you just have a long position in futures for a single product. The CCP will calculate the potential Variation and Initial Margin at the end of day and make sure that there is sufficient collateral. If not, then additional cash will be requested.
The Variation Margin part of the calculation is easy. It will be the implied profit or loss based on the change in price from the previous close – if you are on the right side of the market it will be a credit, and if not it will be a debit.
But what about the Initial Margin? Intuition would say that it is bound to increase because of the increase in volatility. However, if you haven’t changed your position, it is most likely to remain the same.
SPAN uses scenarios that are based on fixed price moves in the futures. So the calculation will be the same as the night before. Any potential increase in the scenario levels will need to be reviewed before it is applied and this process takes time. Usually the SPAN scenarios are only reviewed on a monthly basis, although an emergency review is possible.
If you happened to have a more complex portfolio which included offsets between different products, the margin still wouldn’t change because the number of offsets given within the SPAN algorithm, and hence the savings, are based on the number of lots of each and not their relative values. Changing these ratios is something that is also dependent on a review of the SPAN parameters.
Sufficient collateral will already have been posted to cover the Initial Margin as it hasn’t changed. So any intra-day margin call will be based on the change in Variation Margin.
The same isn’t quite true for options as these are non-linear instruments, but as the parameters aren’t varying, any change in Initial Margin will depend on how much the delta of the option changes. If your portfolio contains options close to maturity then this could be a large swing.
WHAT HAPPENS IF THE INITIAL MARGIN IS BASED ON VAR?
The result will be slightly different if the Initial Margin algorithm is VaR based, but not much.
The intra-day price move could be included as a new scenario in the VaR calculation. As Filtered Historical VaR tends to be the chosen methodology, the increased volatility will be used to scale the scenarios to current volatility. In addition, if the scenarios used are relative rather than absolute, and if the market move is down, you may actually find that your Initial Margin decreases because it is now looking at various percentage moves in a lower base price.
WHY DO I SEE LARGE MARGIN CALLS FOLLOWING A BIG PRICE MOVE?
On the assumption that the volatility in the market hasn’t encouraged you to trade and therefore change your portfolio, then the margin call you are receiving following a large price move is almost entirely down to Variation Margin.
The level of your Initial Margin is likely to be very similar, if not the same, as it was the day before.
You may even find that if you have been asked for additional funds intra-day, at the end of the day some of this may be returned. This is because markets often bounce back, so parts of a large market move will be recovered by the end of day. If the intra-day margin was determined at the peak of the market then the Variation Margin will show a greater loss than that calculated at the end of day – and hence funds being returned.
EXAMPLE MARGIN CALCULATION
5th February 2018 was a particularly volatile day on the US stock markets. The Dow ended the day more than 1000 points lower in its biggest points drop ever and the S&P 500 finished more than 4% down, amid fears over interest rate rises.
After big moves overnight in the Far East, on 6th February the volatility continued on the European stock markets, with the FTSE 100 ending 2.6% lower and the Dax shedding around 2.4%.
The examples below show the margin impact for the E-mini S&P contracts cleared by CME and FTSE 100 Index Futures cleared by ICE Clear Europe.
S&P E-MINI FUTURES
Assume a position of long 100 E-mini S&P March Futures. The SPAN Initial Margin and value has been calculated for end of day 2nd February, intra-day 5th February and end of day 6th February, using the SPAN parameter files published by CME.
If 100 long 2700 March Options are added to the portfolio then the results are as follows:It can be seen that the Initial Margin stays consistent. The intra-day parameter file shows the start of the downward move in the S&P.
Between end of day 2nd and end of day 5th the delta of the option went from 0.6583 to 0.33. This move can be clearly seen in the change in Initial Margin and Equity Value.
FTSE 100 INDEX FUTURES
Now consider 100 Long March FTSE Index Futures. The SPAN Scanning Range for these contracts was £3,230 per lot for both 5th and 6th February. This is an implied move in the index of 323 points.
As the Scanning Range did not change, the Initial Margin stayed constant at £323,000.
The settlement prices were as follows:
- 5th February – 7281
- 6th February – 7099.5
This is a change in price of 181.5 which would result in an end of day Variation Margin of -£181,500. ICE would have requested around this amount of additional margin during the day when the FTSE hit these levels. This could then be used to cover the Variation Margin call at end of day, but no additional funds would be requested to cover Initial Margin.
Contrary to common expectation, under the SPAN methodology, Initial Margin is insensitive to market volatility on a day to day basis.
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