Market Operations - Alternative Calculations

Alternative Calculations
As stated earlier in this chapter, margin requirements in the futures market are set for speculators. Hedgers generally have a lower hurdle when establishing a new position. To go back to our ethanol example, the July 2006 maintenance margin was $4,500/contract. While a speculator would have to increase that by 35% to $6,075 to meet initial margin requirements, a hedger would not. The hedge margin would be $4,500, regardless of whether it is an initial or ongoing position.

"Spread margins" are a bit more complicated. First, we need to be clear on what a "spread" is: the simultaneous buying and selling of two related but non-identical contracts. Spreads are inherently less volatile than either position left uncovered. As we stated before, a margin in the futures markets is the maximum likely movement in the contract price, so it follows that there should be a lower margin requirement for a spread than for an uncovered position.

We will now demonstrate how to calculate a spread margin on a speculative position according to the traditional "delta-based" technique. (A newer, more precise "scan-based" technique is used by traders in the more rarified Treasury obligation futures markets.)

As a starting point we assume that the exchange, CBOT in this case, prescribes a 70% "spread credit" for this transaction. That is, the exchange believes that this spread takes 30% of the volatility out of the equation.

Let's also assume that the spread involves buying soybean meal contracts and selling soybean oil contracts. It could be the other way around – selling meal and buying oil – and it won't affect the net margin.

What will affect the net margin is the ratio. Here we assume that for every two meal contracts bought there are three oil contracts sold. Again, we're assuming a speculative position and, thus, an initial margin higher than the maintenance margin:

Commodities
Maintenance Margin
(per contract)

Initial Margin Mark Up %
Spread Credit Percentage Initial Margin
(per contract)

Soybean Meal
$825
135%
$1,114
Soybean Oil
$725
135%
$979

1. Calculate the outright maintenance margin on each leg of the spread independently. As a reminder, we're assuming that there are two meal contracts for every three oil contracts, so we simply multiply the maintenance margin by the number of contracts:

Commodity
Maintenance Margin
(per contract)

Ratio
Total Maintenance Margin
Soybean Meal
$825
2
$1,650
Soybean Oil
$725
3
$2,175

2. Calculate the amount of the spread credit for each leg by multiplying the total maintenance margin by the spread credit, which is given at 70%:

Commodity
Maintenance Margin
(per contract)

Ratio
Total Maintenance Margin
Spread Credit Percentage
Amount of Spread Credit
Soybean Meal
$825
2
$1,650
70%
$1,155
Soybean Oil
$725
3
$2,175
70%
$1,523

3. Subtract the spread credit from the outright maintenance margin for each leg:

Commodity
Maintenance Margin
(per contract)

Ratio
Total Maintenance Margin
Amount of Spread Credit
Spread Margin per Leg
Soybean Meal
$825
2
$1,650
$1,155
$495
Soybean Oil
$725
3
$2,175
$1,523
$652

4. Sum the spread margin per leg. In this example, the total spread margin would be $1,147, well below the $3,825 maintenance margin for the two positions taken separately. To figure the initial spread margin, simply multiply the maintenance spread margin by the standard initial mark-up, in this case 135%. That gives you $1,548, compared with $5,165 for the total uncovered positions (two contracts at $1,114 each, plus three contracts at $979 each, or $2,228 + $2,937).

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