Definition
Variation margin is a term used in trading to refer to the additional funds that must be deposited by a trader with their broker due to negative price movements in the underlying assets or securities. It is essentially used to bring the margin account back up to the required maintenance margin level and ensure sufficient collateral. This mechanism is deployed to mitigate potential losses that could occur in volatile market conditions.
Key Takeaways
- Variation Margin refers to the extra funds a futures contract holder might need to provide to the clearing house to cover possible losses. It’s essentially the financial safeguard that maintains the integrity of futures trading.
- Variation Margin is not a fixed cost, but it varies daily according to market conditions. This means that if the market moves against a futures position, the futures contract holder will have to pay additional money beyond the initial margin to balance their account.
- The settlement of a variation margin occurs on a daily basis till the contract expires. It’s important for the investor to monitor their investment closely, as there’s a potential need to provide additional funds frequently. Not adequately meeting variation margin calls could potentially lead to the liquidation of the futures position.
Importance
Variation Margin is an essential concept in finance, primarily in the field of derivatives trading. It helps in managing and mitigating the risk associated with potential future losses.
It is a further deposit of funds that is required by a broker or exchange when the price movements of the held securities increase the potential future losses. If the securities prices move unfavorably, then more funds would be required.
Therefore, these additional funds or securities help in ensuring that the investor can meet the obligations of the financial contract. In practical terms, variation margin ensures the credibility and smooth functioning of the futures and options market by preventing traders from defaulting on their obligations due to adverse market movements.
Thus, it plays a critical role in ensuring market stability.
Explanation
Variation margin, in the financial world, serves a crucial function of mitigating the risk associated with financial trading, particularly in futures and options. It is a collateral posted by a trader to a clearing firm, which is used to cover potential losses that might occur due to changes in the price of the security.
It safeguards both parties involved in a trade by ensuring that in the event of a sudden shift in the market, there will be secured funds to absorb the resulting losses and sustain the execution of trades. The calculation and posting of the variation margin is performed on a daily basis to consistently monitor and manage the ever-changing market risk.
When a position moves against a trader, the clearing firm will make a margin call, demanding the trader to top up their account to reach the initial margin requirement. Conversely, if the situation benefits the trader, the excess margin will be returned.
In essence, the variation margin acts as the financial buffer to secure ongoing trades and maintain market integrity, promoting a fair and stable trading environment.
Examples of Variation Margin
Commodity Trading: In the commodity markets, traders often use futures contracts to manage risk. For example, a farmer might sell futures contracts for his crops to lock in a price ahead of time. After the contract has been made, the price of the crops may fluctuate. If it goes down, the farmer will be obliged to pay variation margin to the buyer to make up for the decline in price.
Stock Market Trading: Variation margin is also a common scenario among stock traders when dealing with options and futures. If a trader buys a futures contract on a stock index and the index drops significantly, the trader will have to pay a variation margin to their broker. The amount of variation margin will be equivalent to the decline in value of the futures contract.
Forex Trading: A company in the business of importing or exporting goods can be exposed to a lot of foreign exchange risk. In order to hedge this risk, they may use forex futures. If the value of the currency they are hedging against deviates significantly, the company would be required to pay variation margin to their forex broker. This ensures that the broker is protected against losses due to large movements in currency exchange rates.
Variation Margin FAQs
What is variation margin?
Variation margin refers to the incremental payments of funds required by a clearing house from its members to cover losses they may incur due to adverse price movements of the securities they have traded.
How is variation margin computed?
Variation margin is computed by comparing the current price of the securities to the price at the time of the trade. The difference represents the potential loss and is the amount required for the margin.
Why is variation margin important in finance?
Variation margin is important in finance as it helps manage the risk that one party of a financial contract will not fulfill their contract obligations. It ensures that the value of the contract for both the parties remains zero.
Is the variation margin the same as initial margin?
No, the variation margin is not the same as the initial margin. While the initial margin is the amount of funds required at the time of trade, the variation margin is the incremental payments required due to price movements of the securities.
Can the variation margin be negative?
Yes, the variation margin can be negative if the price of the securities has risen since the time of the trade. This is because the potential loss would be in favour of the trader who would then receive a payment instead of having to pay.
Related Entrepreneurship Terms
- Initial Margin
- Futures Contract
- Margin Call
- Mark-to-Market
- Collateral
Sources for More Information
- Investopedia: Investopedia provides clear education on all things finance, including Variation Margin.
- Reuters: Reuters offers global financial news and resources. It often includes terms like Variation Margin in its reporting.
- The Balance: The Balance provides expertly crafted financial information and explains complex concepts like Variation Margin in an easy-to-understand way.
- Bloomberg: Bloomberg covers finance news around the world and includes resources for understanding finance-related concepts and terms like Variation Margin.
