Dealing with cross margins

If prices move away from the favourable side of your position, you will lose money. In that case, you will have to pay an additional variation margin to maintain coverage of the risk involved.

Of course, it is possible to have more than just one position. For instance, you might be of the opinion that macro economic shifts will result in the Japanese Nikkei225 index to rise and at the same time the MSCI Singapore index will fall. If so, you may buy Nikkei225 index futures and sell MSCI Singapore index futures.

When this is set up at the same time, it is called a cross spread. You might even call it a cross hedge because when something bad happens in the world, you may expect a fall of all markets. Therefore the loss of the long futures will (partially) be offset by the profits of the short futures.

This is the reason that the Singapore exchange SGX, for example, offers nice savings for margins between these index futures contracts. If you have two opposite positions in two different products, you are offered a discount on the margins. These are called cross margins.

For example

Buy long 1 lot SGX NK and sell short 2 lots of SGX SG. As you can see the amounts are not the same; this is because the underlying values differ. By using a ratio of one to two, this reflection is made more comparable.

If you were to pay two separate margins you would be paying a total margin of around USD 3,350, but because of the cross margin calculations you need to reserve only 60%. This discount of 40% results in a cross margin of just 2,000 dollar.

By using cross margins, exchanges and clearing houses show their insight in the financial markets. They have highly sophisticated risk-management systems, which are necessary to operate efficiently.

These cross margins are also frequently used in the oil business. Cross hedges often also occur. I can imagine that when DME starts to list Oman-backed futures in Q4 of this year, liquidity will be at a low level. People will first have got to experience this new exchange for a while, although in this particular case that might only be a few days.

Until the moment of high liquidity, traders can hedge their position of DME futures on NYMEX by setting up an opposite position in the very liquid futures on West Texas Intermediate. All clearing houses involved are also doing business at NYMEX, and therefore they can easily offer cross margins.

Spread trading

Sometimes the set up of a cross transaction is not just because of the lack of liquidity in one leg, but also because of the difference between two prices. This is called spread trading. With this you attempt to profit from an over-bought situation in one product compared to another product.

With this strategy, there is no opinion of the market direction, but it is purely based on the over or undervaluation of a certain product. You attempt to profit from the correlation factor that is being calculated over time. Take a look at the difference between the Brent crude and Dubai oil, for instance.

The amount of margin savings is dependent on the correlation between two products. These figures are, of course, based on past experience. Unfortunately, this has never been a guarantee for the future. So, things might change. Focus and stay sharp!