Understanding CFD Margin Calculations

Posted by fts on 13 July 2010

CFD Margin requirements
An initial margin amount is needed to open a Contract for difference position, either long or short. There are two kinds of margins which are applied to the total value of a Contract for difference position. These 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. That’s why, if you bought 10,000 XYZ CFDs at $1.35, you would be required to have a minimum of $1,350 in your account to cover the minimum margin requirement (10% of your total position size of $13,500). The margin requirement for index and foreign exchange CFDs can even be as little as 1%.

Variation Margin
Variation Margin is the difference between the initial margin and the margin needed to hold the position open as the position value changes. Here is an example if you buy 2,000 XYZ CFDs, at $5.60 it would give you a position value of 2,000 x $5.60 = $11,200. Assuming XYZ is margined at 10% you would need no less than $1,120 initial margin to open this position. If XYZ goes down to say, $5.40, you would now have a loss of $400 ($0.20 x 2,000). This loss (often called variation margin) is subtracted from the initial margin of $1,120, leaving a deposit of $720. Since you still 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 also, the initial margin has been reduced to $720. This is $360 less than the margin required to keep the position open, which means more margin is required to top up the account. The shortfall in margin is called a shortage in equity. If you can’t maintain your margin requirement you will not be able to extend your position however you will always have the ability to reduce or close a position.

Equity Balances
The equity (or balance) of your account will vary in line with the cash you’ve deposited or withdrawn out of your account, the profits or losses in your account and the size of the positions held.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 current 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 final traded price). The equity balance is used to assess your available margin against current positions, and potential new positions you may need to take. Your cash balance is used to ascertain if there’s a requirement for added margin deposits on your account. Once a Contract for difference trade is opened, variation margin requirement must always be maintained on your open positions. It’s your duty to make sure that your account is sufficiently margined always, particularly throughout volatile trading periods. You will only be allowed to trade and retain open positions on the basis of cleared funds within your account, not on promised funds or money in transit therefore it’s essential to allow enough time for funds to clear when depositing money into your account.

If a position turns into profit, the rise in the equity of your account makes it possible for for further positions to be opened.

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

Margin Calls
If ever 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 cut back 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 are required to add additional funds to maintain your open positions.

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

Margin, leverage and risk
Margin as well as the associated leverage can be very useful if you use it correctly. It can also be devastating to the inexperienced trader who has little understanding of the dangers of using leverage and not using a defined risk management plan. There are several ways of using the leverage available by trading Contracts for difference, from the most conservative to one of the most aggressive. The way in which you employ leverage will depend upon your own circumstances.

Prior to trading CFDs make sure you read the Product Disclosure Statement (PDS) your CFD broker issues as this will explain in detail how your CFD broker deals with margin. You must also read this free guide to CFDs, which explains leverage and margin in detail.

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