CFD Margin requirements
An initial margin amount is required to open a Contract for difference position, either long or short. There are a couple of kinds of margins which 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 position. That’s why, if you purchased 10,000 XYZ CFDs at $1.35, you would be required to have at the least $1,350 within your account to cover the minimum margin prerequisite (10% of the total position size of $13,500). The margin prerequisite 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 keep the position open as the position value changes. As an example, if you buy 2,000 XYZ CFDs, at $5.60 it will give you a position value of 2,000 x $5.60 = $11,200. Assuming XYZ is margined at 10% you would want at the very least $1,120 initial margin to open this position. If XYZ falls to say, $5.40, you will now have a loss of $400 ($0.20 x 2,000). This loss (often known 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 $360 lower than the margin required to maintain the position open, which means more margin is necessary to top up the account. The deficit 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’ll always have the ability to reduce or close a position.
Equity Balances
The equity (or balance) of your account will vary in accordance with the cash you have deposited or withdrawn out of your account, the profits or losses within your account and the size of the positions held. In the course of the trading day your account balance, together with all open positions, are valued against the current market rate. Therefore your equity balance is constantly 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 assess your available margin against existing positions, and potential new positions you may need to take. Your cash balance is used to establish if there is a necessity for added margin deposits in your account. Once a Contract for difference trade is opened, variation margin requirement should always be maintained for your open positions. It is your duty to ensure that your account is sufficiently margined always, particularly throughout volatile trading periods. You’ll only be allowed to trade and maintain open positions on the premise of cleared funds within your account, not on promised funds or funds in transit therefore you are required to permit sufficient time for money to clear when depositing money into your account.
If a position turns into profit, the increase in the equity of your account permits for more positions to be opened.
Shortage in Equity
A shortage in equity takes place when the account balance falls below the required initial margin. Accounts having a shortage in equity are generally only allowed to reduce 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 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, known as the ‘Margin Call’, which you must add additional funds to keep 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 the position size) however this will vary between CFD providers.
Margin, leverage and risk
Margin plus 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 hazards of using leverage and not using a defined risk management plan. There are many ways of using the leverage available by trading CFDs, from the most conservative to the most aggressive. The way you utilize leverage will depend upon your own circumstances.
Before trading CFDs you should read the Product Disclosure Statement (PDS) your CFD broker issues as this will explain in detail how your Contract for difference broker deals with margin. You must also read this free guide to CFD investing, which explains leverage and margin in detail.
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