What is variation margin used for in trading?

Variation margin serves a crucial role in managing the risk associated with trading positions, particularly in derivatives markets. It is essentially a margin payment that is made to cover potential losses on a trading position that are realized on a day-to-day basis.

When the value of a position fluctuates, the variation margin ensures that the party with the losing position provides additional funds to the party with the winning position. This is designed to reflect the current market value of the positions held, accounting for gains and losses, and is recalculated daily. As such, it protects the integrity of the trading process by ensuring that all parties are adequately capitalized according to their current risk exposures.

This mechanism is particularly important in preventing defaults and ensuring that all contractual obligations in derivatives trading can be fulfilled. It is critical to understand that variation margin specifically addresses changes in the value of open positions rather than covering initial margin requirements or broadly adjusting capital needs across the portfolio. Therefore, the focus of variation margin is distinctly on ensuring that potential losses are covered in a timely manner following price movements in the market.