Performance Bond

Most of us are familiar with the concept of a performance bond when it comes to construction in the real estate business. In that regard, a contractor is required to take out a performance bond to ensure the property owner that the work will be completed both timely and up to code. In the world of investment, a performance bond is similar in nature in that it is a deposit with the broker which is used as collateral against any losses which might result from an investment.

Futures Performance Bond
A good example of an investment performance bond would be in the futures market. Whenever a customer wants to trade futures, it is necessary to post what is known as either a performance bond or a margin. They are both one and the same and it is likely that you will hear it referred to in both ways. This money is held in the clearing house of the exchange and not with the broker. It is quite simply nothing more than a good-faith deposit in order to assure the broker that enough acceptable collateral, usually cash, is in the account of the customer that would cover losses resulting from a futures market transaction.

How Performance Bonds are Based
Actually, a performance bond is based on the notional (underlying) value of a contract. There is a minimum percentage that is set by the exchange where the product is listed and a broker cannot require a performance bond that is for a smaller percentage. They can however require a larger amount. Most often the percentage is somewhere between five and fifteen percent of the total value of positions being traded. This is a relatively small percentage of the total value, but keep in mind that this percentage will vary from broker to broker. Also, the more volatile the product, the higher the percentage of the total value the performance bond will generally be. This is in place to ensure the broker that maximum losses which could be incurred would be covered. This is in terms of a maximum single day loss.

Key Points to Remember
First of all, it is good to remember that the exchange on which a product has been listed sets the minimum percentages for performance bonds. The broker does have the right to increase that amount but may not set a percentage lower than that established by the exchange. While it appears that the performance bond is in place to protect the broker against losses incurred from an investor’s trade, they also protect the integrity of the industry itself. Since performance bonds are monitored daily, losses are not allowed to accumulate which could result in a trader losing a significant amount of money over the course of several days. In this regard, both the broker and the trader are protected by a performance bond.

Marking to the Market
The way in which performance bonds are monitored is actually quite simple to understand. At each trading day’s end, a settlement price is established by the respective exchanges. Each account is either credited or debited according to that day’s gains or losses. This is what the term ‘marking to the market’ means and you will hear it spoken of repeatedly throughout the course of your investment life. Other markets have different timeframes, such as a three day timeframe in the stock market. The timeframe to be marked is referred to as ‘T’ so that a three day time period for marking to the market would be notated T+3.

One other point to be aware of is that it is possible to lose an amount greater than your margin (performance bond). Therefore, if a broker asks for a substantially higher performance bond than the minimum required by the exchange you will understand why. However, there are valid reasons why these bonds are in place and understanding the principles behind them is vital before leaving a deposit on account when trading.

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