In addition to the Initial Margin that is required in order to open a CFD position, you may also have to pay an additional margin incurred by an adverse price movement in the market, this is referred to as Variation Margin. The Variation Margin is based on the intraday marked to market revaluation of a CFD position.
What is Variation Margin? The variation margin amounts to the difference between the value of the CFD trade at the point of entry, and its value when marked to the closing price at the end of each day (this is known as marked to market). If the client’s total equity falls below the initial margin requirement lodged at the beginning of the trade, a margin call will be made. The client must now either deposit further cash into his or her account, or close out open positions in order to meet the margin requirement.
The use of the variation margin is in distinct contrast to the way that stocks are regularly traded. This is because contracts for difference are in the derivative family, which means they are financial tools that have a value based or derived from an underlying asset, rather than representing ownership of the asset. CFDs are traded on margin, and they can change value to the extent that the entire margin deposited is lost.
Consider, if you trade stocks, the worst that can happen is that you lose all the money that you have paid if the value falls to zero. It does not matter if you track the value as it goes down or not, you will not owe your broker any more money, and there is no reason for the broker to be concerned or even know if you have a winning trade. If instead you are trading CFDs, it is important for your broker or dealer to track the value as they could be left losing money if you could not afford to pay your losses.
The variation margin is sometimes referred to as a maintenance margin. The variation margin is based on the intraday marked to market revaluation of a CFD position. For instance, if you have a long position and the price falls then you are required to pay a variation margin. The variation margin is a percentage of the total position size and the amount required will cover the adverse movement in the value of your position. On the other hand, if you have a short position and the price falls, you would receive a variation margin equal to the positive movement in the value of the position.
Marking to market to calculate the variation market can work in your favour, as if your position has made a profit then the amount is credited to your account each day. This money is available to open additional trades, although you should always consider your overall exposure to risk before trading to the maximum extent allowed by your broker. Again, this is very different from the situation when you are trading stocks. No matter how much stocks increase in value, you will not see any more money in your brokerage account until you decide to sell your shares.
When you receive a variation margin call you must attend to it asap as otherwise your broker may take any steps necessary to stop further losses and recover his money which may lead to the position being compulsorily closed out. This does not only include selling your position for a loss, but also selling any further interests of yours that he holds as he sees fit. There is no requirement for the broker to sell your holdings in any particular order, and he may therefore take actions that you would not want, perhaps cashing in a holding that had great future prospects rather than selling the unexciting trade that you would have preferred him to do. The broker’s terms and conditions will spell this out, but as you are required to respond to the margin call, basically if you fail to do so your CFD provider has the freedom to do what he will to protect his interests. To conclude, you as the position holder are obliged to pay for any shortfall in funds if variation and initial Margins are insufficient to cover the shortfall.
The recent financial crisis brought the marked to market idea into sharp focus. While mortgages were not re-valued, or marked to market, to accord with their current value, the financial house of cards was intact; but as soon as the fall in value of housing was incorporated in the valuations, it became obvious that the banks had insufficient assets to cover their liabilities, and this led to the market collapse.