Buying on margin involves buying as asset without having to have funds equal to the asset's price available. It is often possible for investors to finance part of their positions in underlying assets by borrowing, usually from their brokers.
For example, in the US, investors can purchase common stock through registered brokers by putting up as little as half of the purchase price. In turn, the brokerage firm arranges for the investor to borrow at most half of the price. The investorâ€™s contribution is called the margin deposit. The 50% contribution is the initial margin requirement. For example, for a $100 stock, the required initial margin deposit might be $50.
In addition, once a position is open, the market may set rules which require the investor to maintain at least a certain level of margin. In many cases, this maintenance margin (also known as variation margin) requirement is lower than the initial margin requirement.
Public margin requirements for futures are set by exchanges and depend on the volatility of the underlying asset, with higher required margin going with higher volatility. Since their obligations are symmetric, margin is the same for both buyers and sellers, usually about 3%-8% of the underlying asset exposure.
Initial margin required when the futures position is first opened is usually higher than the margin required to maintain it. In a procedure that differs from the stock market, however, whenever the percentage margin falls below the maintenance level, the futures position must be liquidated or the margin restored to its initial level. In the stock market, it is sufficient to restore the margin to its maintenance level.
Public margin requirements for exchange-traded options have their own economic logic. Purchased options must be fully funded by the investor; he cannot borrow money from his broker to buy them. This makes sense, since options can already be quite risky securities compared to holding the underlying asset. It is much easier to lose 100% of the investment (should an option end up out-of-the-money). Of course, there is no need for the buyer to put up funds in addition to the cost of the option, since under no circumstance can he be obligated to pay out more money.
In contrast, the seller has this obligation should the option finish in-the-money. For example, selling a call without first holding the underlying asset is termed selling an uncovered call. This action could potentially require substantial additional funds to buy the underlying asset for delivery at exercise. As a result, not only is the seller required to leave the proceeds of the call sale with his broker, he must also deposit additional capital. This additional amount is greater for individual equity options than for broad-based index options, probably because a typical equity is more risky (volatile) than an index portfolio, which has reduced risk through the wonders of diversification.
Since June 1988, US exchange-traded standard options which are at- or in-the-money, (in addition to 100% of the proceeds) a deposit of 20% of the underlying asset price is required. For out-of-the-money options, the amount is 20% of the underlying asset price reduced by the amount by which the option is out-of-the-money; in any event, the margin must be at least 10% of the asset price. Options on broad stock indexes, with their typically lower volatility, require less margin: 15% instead of 20%. For equity and index options, no distinction is made between initial and maintenance margin.
However, if the call is sold covered, so that the seller simultaneously holds the underlying asset, then no margin is required. In this case, the broker is unconcerned since, should the call finish in-the-money, the seller is already holding the asset that may be needed for delivery. Indeed, current margin regulations actually permit the covered call seller to borrow up to 50% of the cost of the underlying asset and to use the proceeds of the sold call to help pay for the asset.