Both futures and options can be margined in varying ways. Two different types of system have evolved for each of these products: futures margining systems are distinguished by the way they handle current exposures, that is, whether these exposures are returned to zero by payments of cash or whether they are collateralised. These two types of futures margining system are sometimes referred to as cash and non-cash clearing systems. Options margining systems differ as to whether the premium is paid upfront (that is, when the option is purchased) or paid over the life of the option. The former system in which the premium is paid upfront is often referred to as options-style margining, and it is the most prevalent type of margining system used for options. The other system for margining options ­ paying the premium over the life of the option - is often referred to as futures-style margining because of the cash payments that go back and forth between the option seller and purchaser as positions change in value, just as cash payments go back and forth between buyers and sellers of futures contracts in a cash clearing system. Futures-style margining has been developed for use with options on futures contracts to enable market participants with a portfolio of these contracts and their underlying futures to match cash flows from margin payments (a variation margin payment due on a futures contract can be matched with a variation margin payment receivable on an offsetting option on the future, for example).

Any margining system must provide protection to the clearing house from the current credit exposure that it faces vis-à-vis clearing members as well as from the potential for these credit exposures to increase in the future. All margining systems require contract holders to post collateral to cover potential future exposures (generally measured over one business day). The systems differ in their approach to the coverage of current credit exposures. In a cash clearing system for futures or a system for options in which the premium is paid over the life of the contract, current exposures are returned to zero each day by marking positions to market, by collecting losses from clearing members whose portfolios have a negative market value, and by paying out gains to clearing members whose portfolios have a positive market value. A non-cash clearing system for futures or a system for options in which the premium is paid upfront also marks positions to market each day, but current exposures cumulate and are collateralised.

The summary below explains how a clearing house would margin either a futures contract or an option contract under these systems.

Futures contracts

Cash clearing. When two parties enter into a futures contract, both the seller of the contract and the buyer of the contract are required to post collateral to cover the potential future credit exposure that they pose to the clearing house. This collateral is often referred to as initial margin. Positions are marked to market daily, and these current exposures are extinguished by cash payments (known as variation margin) from clearing members holding losing positions to the clearing house and from the clearing house to clearing members holding profitable positions.

Non-cash clearing. The mechanics for non-cash clearing differ from those for cash clearing with respect to the treatment of current exposures. Positions are marked to market daily in the non-cash system, as in the case of the cash system, but no variation margin payments are made. Instead, current exposures are collateralised. Because of the zero-sum nature of a futures contract, if collateral requirements for a long position go up, for example, those for a short position will go down, but there is no pay-through of gains and losses as in the cash clearing system. One position simply has higher collateral requirements and the other position has lower requirements. Excess collateral can be withdrawn in some (but not all) non-cash systems, but this typically does not occur automatically (in contrast to a cash clearing system). The clearing house also protects against potential future exposures by requiring the posting of collateral; this collateral is in addition to that required to cover current exposures, however.

Option contracts

Premium paid upfront. In this margining system, the purchaser of an option pays the premium for the option when the deal is struck. The purchaser poses no further risk to the clearing house after this payment. (An exception is if the purchaser elects to exercise the option, in which event the clearing house may need to take steps to ensure its performance.) The seller of the option, however, has a continuing obligation to perform, and the clearing house must protect itself from this exposure. The seller of the option posts collateral to cover the potential future exposure from the position. The position is marked to market daily, and the current exposure is collateralised.

Premium paid over the life of the contract. In a margining system in which the premium is not paid at the initiation of the contract, both the purchaser and the seller of the option contract post collateral to protect the clearing house against potential future credit exposures. Both sides of the contract are marked to market daily; cash payments, or variation margin, are used to reset current exposures to zero. The premium is paid to the seller of the contract over time in the form of the daily variation margin payments through the life of the contract and on final close-out.

An example helps illustrate this point. A market participant sells a December short sterling option for 0.20, tick size for the contract is 0.01, and the value of a tick is £12.50. Given the daily price moves shown below, the series of variation margin payments and receipts by the seller of the option would be:

Day	Trade price	Closing price	Price movement	Variation margin	Cumulative variation margin
1	0.20	0.19	- 0.01	12.50CR	12.50CR
2		0.21	+ 0.02	25.00DR	12.50DR
3		0.20	- 0.01	12.50CR	0.00CR
4		0.15	- 0.05	62.50CR	62.50CR
At expiry the option has a value of 0.14 and is exercised
5		0.14	- 0.01	12.50CR	75.00CR
Total variation margin over duration of position 75.00CR

If the option is exercised on day 5, the buyer pays the seller the option value of £175.00 = (14*£12.50*100). The total amount paid to the seller is, therefore, £250.00 = (£175.00 + £75.00), the agreed premium for the trade of 0.20*£12.50*100.