Buying a Contract For Difference uses margin to create massive leverage. Only a small portion of the actual asset value needs to trade hands when purchasing a CFD. It is important to be able to both calculate the margin necessary and understand the two types of margin that exist: initial margin and variation margin. Doing so will enable the investor to determine his risk and reward, as well ensure he has enough capital to fund his strategy.
Margin requirements are set by the SFECC, or the Sydney Futures Exchange Clearing Corporation, although your broker or dealer may be allowed to impose further margin requirements beyond these.
Initial Margin
The initial margin necessary to take up a position is quite straight forward. Your CFD provider will list any margin requirements. This is often 5% of the total asset but could be much different depending on the liquidity and volatility of the CFD.
| Company | ASX Code | Margin* | |
|---|---|---|---|
| 1 | BHP Billiton Ltd | BHP | 5% |
| 2 | Commonwealth Bank of Australia | CBA | 5% |
| 3 | Westpac Banking | WBC | 5% |
| 4 | ANZ Bank | ANZ | 5% |
| 5 | Telstra | TLS | 5% |
| 6 | Wesfarmers | WES | 5% |
| 7 | Woolworths | WOW | 5% |
| 8 | Rio Tinto | RIO | 5% |
| 9 | Westfield | WDC | 5% |
| 10 | Newcrest Mining | NCM | 10% |
| 11 | Lihir Gold | LGL | 10% |
| 12 | Macquarie Airports | MAP | 10% |
| 13 | Seek LTD | SEK | 10% |
| 14 | Sonic Healthcare | SHL | 10% |
| 15 | Virgin Blue | VBA | 10% |
| 16 | Centro Retail Group | CER | 15% |
| 17 | Tishman Speyer Office Fund | TSO | 15% |
| 18 | Cromwell Group | CMW | 15% |
| 19 | Bow Energy Ltd | BOW | 25% |
| 20 | Hutchinson Telecomm | HTA | 25% |
*Margin requirement by CMC Markets as of 7/6/10
Here is an example of calculating the initial margin on a CFD for Woolworths Limited (WOW).
| How to Calculate Initial Margin | |
|---|---|
| Share Price = $28.13 | CFD Shares Desired = 1,000 |
| $28.13 x 1,000 = $28,130 total asset value | $28,130 x .05 = $1406.50 margin requirement |
We now know the margin necessary to open such a position with a CFD’s on Woolworths Limited. But what other margin requirements are needed to maintain our position? That type of margin is termed variation margin.
Variation Margin
Once we satisfy initial margin requirement to enter a position, additional funding may prove necessary depending on how the stock performs.
- If our CFD is short on the market and the asset moves upwards, we will need to satisfy the variation margin
- If our CFD is long on the market and the asset drops, we will need to satisfy the variation margin.
Of course, if the underlying asset moves in your desired direction, no additional margin will be necessary since your account will receive a credit. When the asset moves against you and the broker prompts you for additional funding, this is called ‘margin call’. Failure to pay the request for additional margin could result in a complete loss of position as the broker is forced to either close it out or start assuming a loss. As you can imagine, the broker will never assume your losses. The margin rules are quite strict and you usually have a maximum of 24 hours to meet the requirements.
Margins are calculated daily, although they are allowed to be calculated intra-day if needed.
Understanding the Margin Requirements
While the formula for maintaining margin is quite simple, it should be carefully pondered before entering a position. If we purchase a 1000 CFD’s on a $10 stock with a 5 percent margin, we pay $500 dollars to open a position. If the stock were to move against us 10 percent, we might need $1500 or more to maintain our position.
Many traders refuse to accept a loss, and will continue to fund a losing position in the assumption of what goes up must come down, and vice versa. This attitude is not a winning and profitable strategy.
A better method is to set aside a certain amount of capital, whether it be a percentage or a fixed amount, that you are willing to risk on that one trade. Many traders will use 2% of their overall capital while others might use a fixed amount such as $300.
When you can calculate margin, you will be able to determine the amount of CFD shares you can purchase, as well as establish your total risk and potential reward scenarios.