Lastly, let us talk about ‘Margins,’ which simply means taking leverage on trading positions.
Why are margins important?
Margins play a very important role in derivative trading as it enables us to leverage our positions. In fact, margins are the one that gives a Derivative Contract the required financial twist. For this reason, understanding the margins in detail is extremely important.
Margin is a kind of collateral that the parties having the long and the short side of the futures contract need to deposit with his/her broker or exchange before taking any position. The reason, the broker or the exchange takes this collateral, is in order to protect itself from any kind of credit default by any of the parties involved.
For example, if one goes long in the Nifty futures contract and if the Nifty falls, then the long party has to pay for the losses, but if he defaults, the loss has to be borne by the exchange/broker. Thus, in order to protect itself from this potential default, the exchange/broker requires an initial collateral from the trader investor before he can take any (long or short) position.
Margins allow us to deposit a small amount of money and take exposure to a large value transaction, thereby leveraging on the transaction.
Let us discuss this with an example to understand it better.
Kalyan Jewellers agrees to buy 15Kgs of Gold at ₹3000/- per gram from Prabhudas Gold Dealers Gold Dealers, three months from now.
Any variation in the price of gold will either affect Kalyan Jewellers or Prabhudas Gold Dealers negatively. If the price of gold increases then Prabhudas Gold Dealers suffers a loss and Kalyan Jewellers makes a profit.
Likewise, if the price of gold decreases Kalyan Jewellers suffers a loss and Prabhudas Gold Dealers makes a profit.
We know that this kind of agreement which is a typical example of a forward contract, works on a gentleman’s word. Consider a situation where the price of gold has drastically gone up placing Prabhudas Gold Dealers in a difficult spot.
Clearly Prabhudas Gold Dealers can say they cannot make the necessary delivery and thereby default on the deal. Obviously, what follows will be a long and legal chase, but that is outside our focus area. The point to be noted here is that, in a forward agreement the scope to default is very high.
Since futures and options market are an improvisation of the over the market trades, the issue of default is carefully and intelligently dealt with. This is where the margins play a role.
What are the different types of margins?
Now how does the exchange make sure that trade works seamlessly and no default takes place? Well, they make this happen by means of –
1. Collecting the margins
2. Marking the daily profits or losses to the market which is known as the mark to mark market (MTM).
Now, we know that at the time of initiating the futures position, margins are blocked in your trading account. The margins that get blocked is also called the “Initial Margin”
Initial Margin will be blocked in our trading account for how many ever days we choose to hold the futures trade. The value of initial margin varies daily as it depends on the futures price.
Initial Margin = % of Contract Value.
Contract value = Futures Price * Lot Size
Lot size is fixed, but the futures price varies every day.
This is the first initiated amount that must be deposited in the margin account at the time a future contract is entered into.
Amount of initial margin is calculated by National Securities Clearing Corporation Ltd (NSCCL) based on the Standard Portfolio Analysis of Risk (SPAN) methodology (commonly known as NSE SPAN). The objective of this methodology is to estimate the risk element in the portfolio of all the derivative contracts of each member.
NSE SPAN determines the largest amount of loss that an open position can incur in 99% of days. It is also known as the 99% Value at risk (VaR) approach. For liquid stocks, the margin covers one day losses whereas for illiquid stocks, it covers three-day losses to allow the exchange to liquidate the position over three days. This amount is collected by NSCCL from clearing members who in turn collect the same from their trading members and clients.
Mark to Mark Margin
As we know the futures price fluctuates on a daily basis, because of which we either stand to make a profit or a loss. Marking to market, or mark to market (MTM) is a simple accounting procedure which involves adjusting the profit or loss we have made for the day and entitling us the same.
As long as we hold the futures contract, MTM is applicable.
Let us take up a simple example to understand this.
Assume on 1st April at around 9:30 AM, you decide to buy ABC Ltd Futures at ₹165/-. The Lot size is 3000. 4 days later on 4th April, you decide to square off the position at 2:15 PM at ₹170.10/-. So is a profitable trade –
Buy Price = ₹165
Sell Price = ₹170.1
Profit per share = (170.1 – 165) = ₹5.1/-
Total Profit = 3000 * 5.1 = ₹15300/-
However, the trade was held for 4 working days.Each day the futures contract is held, the profits or loss is marked to market. While marking to market, the previous day closing price is taken as the reference rate to calculate the profit or losses.
The table shows the futures price movement over the 4 days the contract was held.
Let us look at what happens on a day to day basis to understand how MTM works –
On Day 1 at 11:30AM the futures contract was purchased at ₹165/-, clearly after the contract was purchased the price has gone up further to close at ₹168.3/-. Hence profit for the day is 168.3 minus 165 = ₹3.3/- per share. Since the lot size is 3000, the net profit for the day is 3.3*3000 = ₹9900/-.
Hence the exchange ensures (via the broker) that ₹9900/- is credited to your trading account at the end of the day.
But the question is where is this money coming from?
Obviously, it is coming from the counterparty. Which means the exchange is also ensuring that the counterparty is paying up ₹9900/- towards his loss.
But how does the exchange ensure they get this money from the party who is supposed to pay up? – They do it through the margins that are deposited at the time of initiating the trade.
Now here is another important aspect we need to note – from an accounting perspective, the futures buy price is no longer treated as ₹165 but instead it will be considered as ₹168.3/- (closing price of the day 1).
Why is this happening?
Well, the profit that was earned for the day has been given to you already by means of crediting the trading account. so next day is considered a fresh start. Hence the buy price is now considered at ₹168.3, which is the closing price of the day 1.
On day 2, the futures closed at ₹172.4/-, clearly another day of profit. The profit earned for the day would be ₹172.4/ – minus ₹168.3/- i.e. ₹4.1/- per share or ₹12300/- net profit.
The profits that you are entitled to receive are credited to your trading account and the buy price is reset to the day’s closing price i.e. ₹172.4/-. Likewise, its done for Day 3.
Now On day 4, the trader did not continue to hold the position through the day, but rather decided to square off the position mid-day 2:15 PM at ₹170.10/-. Hence with respect to the previous day’s close he again made a loss. That would be a loss of ₹171.6/- minus ₹170.1/- = ₹1.5/- per share and ₹4500/- (1.5 * 3000) net loss.
Needless to say, after the square off, it does not matter where the futures price goes as the trader has squared off his position. And ₹4500/- is debited from the trading account by end of the day.
Well, if we add up all the MTM cash flow we will end up the same amount that we originally calculated, which is –
Buy Price = ₹165/-
Sell Price = ₹170.1/-
Profit per share = (170.1 – 165) = ₹5.1/-
Total Profit = 3000 * 5.1
So, the mark to market is just a daily accounting adjustment where –
1. Money is either credited or debited (also called daily obligation) based on how the futures price behaves
2. The previous day close price is taken into consideration to calculate the present day MTM.
Why do you think MTM is required?
MTM is a daily cash adjustment by means of which the exchange drastically reduces the counterparty default risk. As long as a trader holds the contract, the exchange by virtue of the MTM ensures both the parties are fair and square on a daily basis.
Let us now relook at margins keeping MTM in perspective. As mentioned earlier, the margins required at the time of initiating a futures trade is called “Initial Margin”.
Each and every time a trader initiates a futures trade (for that matter any trade) there are few financial intermediaries who work in the background making sure that the trade carries out smoothly. The two prominent financial intermediaries are the broker and the exchange.
Now if the client defaults on an obligation, obviously it has a financial repercussion on both the broker and the exchange. Hence if both the financial intermediaries have to be insulated against a possible client default, then both of them need to be covered adequately by means of a margin deposit.
In fact, this is exactly how it works – Initial margin is the minimum requisite margins blocked as per the exchange’s mandate which cushions for any MTM losses. This is specified by the exchange and this initial margin is blocked by the exchange.
Maintenance margin is the minimum amount of equity that must be maintained in a margin account. If due to MTM, the margin account falls below the stipulated level, maintenance margin call is there. It protects both investors and the broking house. The broker does not have to absorb excessive investor losses while the investor is in a situation to avoid being totally wiped out.