Contract for difference Margin requirements
An initial margin amount is needed to open a CFD position, either long or short. There are two sorts of margins that are applied to the full 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 full notional value of the trade. Hence, if you purchased 10,000 XYZ CFDs at $1.35, you would be required to have no less than $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 is often as little as 1%.
Variation Margin
Variation Margin is the difference between the initial margin and the margin required to hold the position open as the position value changes. To illustrate 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 not 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 (referred to 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 have a margin requirement of $1,080 (i.e. 2000 x 5.40 x 10%). There is now a paper loss of $400 also, the initial margin has been reduced to $720. This is now $360 less than the margin required to maintain the position open, which means more margin is required to top up the account. The shortfall in margin is known as a shortage in equity. If you cannot sustain your margin requirement you won’t be able to extend your position however you will always be able to reduce or close a position.
Equity Balances
The equity (or balance) of your account will rise and fall according to the cash you’ve deposited or withdrawn from your account, the profits or losses affecting your account and the size of the positions held. In the course of the trading day your account balance, including all open positions, are valued against the current market rate. Hence 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 current positions, and potential new positions you may need to take. Your cash balance is used to determine if there is a requirement for additional margin deposits on your account. Once a CFD trade is opened, variation margin requirement must always be maintained for your open positions. It’s your duty to make sure that your account is satisfactorily margined at all times, especially during volatile trading periods. You will only be allowed to buy and sell and retain open positions on the premise of cleared funds in your account, not on promised funds or money in transit for that reason you are required to permit sufficient time for money to clear when depositing cash into your account.
If a position turns into profit, the increase in the equity of your account allows for 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 with a shortage in equity are generally only allowed to scale back 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 ever the market moves against you and your equity balance falls below your initial margin you usually have the choice of:
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, known as the ‘Margin Call’, which you are required to add additional funds to keep your open positions.
Stop Out Level
You are in danger that your open positions will generally be closed if you have less than 40% of the required initial margin (i.e. 40% of your position size) however this will likely vary between CFD providers.
Margin, leverage and risk
Margin and the associated leverage can be very useful if you use it correctly. It can also be devastating to the inexperienced trader that has little understanding of the risks of using leverage with no defined risk management strategy. There are many ways of using the leverage available by trading CFDs, from the most conservative to one of the most aggressive. The way you employ leverage will depend upon your personal circumstances.
Before trading Contracts for difference you ought to read the Product Disclosure Statement (PDS) that your CFD broker issues as this will explain in detail how your CFD broker deals with margin. You should also read this free guide to CFDs, which explains leverage and margin in detail.
