Core Path · L1.7.03

Futures and margining

12 minDerivativesMarginLiquidity

By the end you will be able to

  1. 1Explain daily settlement, initial margin and variation margin.
  2. 2Explain how futures differ from forwards and why a clearing house stands in the middle.
  3. 3Show that daily settlements add up to the same total gain as a forward.
  4. 4Explain why margin calls create a need for cash, even for a good hedge.

Why it matters

On 20 April 2020, a US oil futures contract settled at minus $37.63 a barrel. Sellers paid buyers to take oil away. Every holder settled the loss or gain that same evening, in cash. That daily settlement is the engine of every futures market.

Core explanation

A forward with a referee

A futures contract does the same job as a forward: it fixes today the price of a trade on a future date. The difference is how it is traded. A forward is a private contract with a bank. A future is a standard contract bought and sold on an exchange, with a fixed size, set delivery months and a clearing house in the middle.

ForwardFuture
WhereOver the counterOn an exchange
TermsTailoredStandard size and dates
CounterpartyThe other firmThe clearing house
Gains and lossesPaid at the endSettled every day
Usual endingDelivery or cashClosed out before delivery

The clearing house. Once a trade is agreed on the exchange, a clearing house (or central counterparty, CCP) steps in. It becomes the seller to the buyer and the buyer to the seller (L1.2.07). Each trader now faces only the clearing house, and does not need to know or trust the other side. To make that safe, the clearing house collects margin.

The margin cycle

  1. Initial margin. Open a position and you deposit initial margin: a buffer big enough to cover a bad day or two.
  2. Daily settlement. Every evening the exchange sets a settlement price. Each position is marked to market: the day's gain is added to your account and the day's loss is taken out. This daily cash is the variation margin.
  3. Margin call. If losses push your balance below the maintenance margin, you get a margin call and must top it back up to the initial margin, usually by the next morning. Fail, and your position is closed.

Words differ by market. Some textbooks use “variation margin” only for the top-up after a margin call. Clearing houses today use it for the daily payment of gains and losses, as we do here, and many simply require each member to restore its initial margin every day.

Closing out. Few futures end in delivery. To leave a position, you close it out: a buyer sells the same contract, the two cancel, and the account keeps whatever gains and losses have been settled along the way.

Why it matters for risk. Daily settlement means no one builds up a large unpaid loss, which protects the clearing house and everyone in it. The price is that losses must be paid in cash at once. A company hedging with futures can be right overall, with its business gaining as its futures lose, and still run short of cash to meet the margin calls. That is funding liquidity risk, and L1.7.12 shows a company that learned it the hard way.

Forward or future?

4 cards

  1. A company agrees with its bank to buy exactly 3.7m Swiss francs on 14 March next year.

  2. A trader buys ten contracts for December delivery on an exchange screen.

  3. Gains and losses are settled in cash every evening.

  4. If the other side goes bust, you may not be paid what you are owed.

The formal version

Write FtF_t for the settlement price at the end of day tt, F0F_0 for the price you traded at, qq for the contract size and nn for the number of contracts. For a long position, the variation margin on day tt is:

VMt=(Ft−Ft−1)×q×n\text{VM}_t = (F_t - F_{t-1}) \times q \times n

Add up every day until you close out on day T:

∑t=1TVMt=[(F1−F0)+(F2−F1)+⋯+(FT−FT−1)]×q×n\sum_{t=1}^{T} \text{VM}_t = \big[(F_1 - F_0) + (F_2 - F_1) + \dots + (F_T - F_{T-1})\big] \times q \times n

Each middle price appears once with a plus and once with a minus, so it cancels:

∑t=1TVMt=(FT−F0)×q×n\sum_{t=1}^{T} \text{VM}_t = (F_T - F_0) \times q \times n

The total is the same as a forward's payoff, ST−KS_T - K per unit, from L1.7.02 (at delivery the futures price equals the spot price). Futures change when the cash moves, not how much moves in total. For a short position, flip the sign.

Try it

An illustrative crude oil contract: 1,000 barrels, initial margin $6,000 and maintenance margin $4,500 per contract (real levels are set by the clearing house and change with volatility). Step through a week, one day at a time. Then try the short side, or three contracts, and watch how fast the calls come.

Try itMargin account, day by day

Open the futures and forwards model →

Price path

Your position

Contracts

balance after the day's settlement cash added after a margin call
12.0k9.0kOpen

Position opened

$12,000

Long 2 contracts at $80.00. Initial margin $12,000 deposited.

Worked example

A week on the falling path

You buy 2 contracts at $80.00. Initial margin is 2 × $6,000 = $12,000; maintenance is $9,000. Prices are US dollars per barrel.

Following the margin account

Step 1 of 5
  1. 1

    Day 1

    Settles at $79.20: a change of −0.80 × 1,000 × 2 = −1,600. Balance $10,400, still above $9,000.

Regulatory lens

Futures exchanges and clearing houses are tightly supervised: in the US by the Commodity Futures Trading Commission (CFTC), and in the EU under the European Market Infrastructure Regulation (EMIR), with ESMA and national authorities. Worldwide, clearing houses follow the CPMI-IOSCO Principles for Financial Market Infrastructures (2012), which require them to collect margin that covers a defaulting member's likely losses with a high degree of confidence, and to hold further resources for extreme days. L1.7.11 explains how these rules grew after 2008.

Sparks

SparkRice futures in eighteenth-century Osaka
The Dojima Rice Exchange in Osaka is often called the first organised futures market. Merchants traded standard contracts on rice that would be delivered later, and the Tokugawa shogunate officially recognised the market in 1730.
SparkMinus $37.63
In April 2020, with demand collapsing in the pandemic, storage near the delivery point for the US benchmark oil contract (WTI) at Cushing, Oklahoma ran short. On 20 April, the day before the May contract expired, it settled at minus $37.63 a barrel. Holders who could not take delivery paid to get out. Daily settlement meant those losses were paid in cash that evening.

Key takeaways

  • A future is a standardised forward traded on an exchange, with a clearing house as counterparty to both sides.
  • Initial margin is a deposit against default; variation margin settles each day's gain or loss in cash.
  • If the balance falls below the maintenance margin, a margin call restores it to the initial margin.
  • Daily settlements add up to the same total as a forward: (F_T − F₀) per unit. Only the timing differs.
  • Margin calls demand cash now, which creates funding liquidity risk even for a sound hedge.

Reaction

Check what stuck

Question 1 · objective 2

Once a futures trade is cleared, who is the counterparty to the buyer?

Question 2 · objective 1

You are long one oil futures contract of 1,000 barrels. The settlement price falls from $80.00 to $78.50. How much variation margin do you pay, in dollars?

$

Question 3 · objective 1

Initial margin is $6,000 and maintenance margin $4,500. Your account starts at $6,000 and you lose $2,000 in a day. How much must you deposit after the margin call?

$

Question 4 · objective 3

You buy one 1,000-barrel futures contract at $80.00. Over three days it settles at $81.20, $79.50 and $83.40, and you close out at $83.40. What is your total gain, in dollars?

$

Question 5 · objective 4

A hedger's futures position loses money for several days while the asset it hedges gains in value. What is the main risk?

Glossary

Futures contract
A standardised forward contract traded on an exchange, cleared by a clearing house and settled every day.
Clearing house (CCP)
Central counterparty, or clearing house: it becomes the buyer to every seller and the seller to every buyer.
Settlement price
The official end-of-day price the exchange uses to settle gains and losses on futures.
Mark to market
Revaluing a position at today's market price and settling the difference.
Initial margin
Cash or securities deposited when a position is opened, to cover losses if the holder defaults.
Variation margin
Cash paid or received each day to settle that day's gain or loss on the position.
Maintenance margin
The balance below which a margin account must be topped up.
Margin call
A demand to deposit more margin, here to bring the account back to the initial margin.
Close out
Ending a futures position by taking the opposite trade in the same contract.

Deep Dives & Origins

Deep Dives

  • John C. Hull, Options, Futures, and Other Derivatives, 11th edition (Pearson, 2021), the chapter “Futures Markets and Central Counterparties”. Beginner.
  • CPMI-IOSCO, Principles for Financial Market Infrastructures (BIS, April 2012), principles 4 to 7. Intermediate.

Origins

  • John C. Hull, Options, Futures, and Other Derivatives, 11th edition, Pearson, 2021.
  • CPMI-IOSCO, Principles for Financial Market Infrastructures, BIS, April 2012.
  • US Commodity Futures Trading Commission, Interim Staff Report, Trading in NYMEX WTI Crude Oil Futures Contract Leading up to, on, and around April 20, 2020, November 2020.

Watch this lesson

Video version

Prefer to watch? The same lesson as a 12-minute video will sit here, made from this page's script.

Previous · L1.7.02

Forwards

Next · L1.7.04

Interest rate swaps