Understanding the "Futures Trading"

Lesson -> The Margin Calculator Part 02

7.1 - Trade information

This chapter will begin with the same question: Why do you believe margins are charged? Let me tell you the truth before you get mad and chase me.

From a risk management perspective, margins are charged. This helps to prevent any unintended counterparty default. The overall risk management is overseen by the risk management system in the broker's office, often called the RMS system. The RMS, which is a computer program that approves all orders from clients, only then can they be sent to the exchange. This takes just a fraction of second. People are constantly monitoring whether everything is correct or not.

You are basically communicating the following information to the risk management system, (RMS), when you place a trade. Let's say you want to buy a futures contracts (via a buy-order entry form).

  1. The contract that you want to purchase (e.g. TCS futures, IDEA forwards, etc.
  2. The number of lots you want to buy
  3. The price you are willing to pay (market or limit).

After you place your order, the RMS system will evaluate the margin requirement and allow your trade to proceed (provided that you have sufficient margin).

The following information is what do not normally give to the RMS system:

  1. Your trade's holding period - this is whether you want to keep your trade open for a single day or over several days.
  2. Stoploss Point - At what price point would you like to book a loss or square off the trade if it goes against you?

What would happen if these additional details were provided to the RMS? It is obvious that the RMS system will have more information to help you understand your risk appetite.

The trade duration, for example, would tell the system how much volatility you are currently exposed to. Intraday trades are not subject to volatility. If your trade is intraday, you only have 1-day volatility. You also have to deal with the 'overnight' risk.

Overnight risk refers to the possibility of holding the position for the night. Let's say I have a long BPCL futures position. This is a major Indian oil marketing company. BPCL is extremely sensitive to changes in crude oil prices. As I hold the BPCL futures, let's say that overnight the crude oil price rises by 5%. This will clearly harm BPCL as it makes it more difficult for BPCL buy crude oil on the international markets. I will lose my BPCL position overnight. Also, an M2M cut. This is known as 'overnight risk'. The point I want to make is simple: From the RMS system's viewpoint, the longer the trade is held, the greater the risk you are exposed.

Think of the stoploss as a tradeexpressing your intended stoploss is better than, as it keeps the RMS system completely unaware of your risk appetite. This is not information you must reveal. The RMS system will provide more information about your trade if you do. If I buy BPCL futures at Rs.649/o, without specifying a stoploss I am virtually exposed to unlimited risk. If I set my stoploss at Rs.9/-, I can book a loss and exit the trade if BPCL falls below Rs.640/– (649 - 9). The RMS system provides valuable information about my willingness to accept the risk.

Both the trade's duration and stoploss give you more information about your risk appetite to RMS. What does this all mean for traders?

Think about it: The RMS system will develop more clarity if you are clearer about the risks you face. You will need fewer margins if your RMS system has more clarity.

This is, loosely speaking, like shopping at a retailer for consumer electronics. Although this analogy may not be the most appropriate, I believe it conveys the message.

A consumer electronics shop will tell you the price of a TV if you ask. If you tell the seller that you will likely purchase 50 televisions, however, he will immediately drop the price.

Tell him that you have the cash and will finish the transaction immediately. He will be more open to this idea and drop his jaws. The bottom line is that the shopkeeper will get more information about the transaction the more attractive the price.

7.2 - Product types

One thing is certain: the less information you provide to the RMS system (in terms risk), the lower the margin. It is obvious that the lower the margins, the more capital you can use. How does a trader communicate this information to the RMS? This information can be used for specific product types. When placing an order to buy or sell, you can specify which product type you want. There are many product types. They differ in their functionality and how they communicate to the RMS system. Although the core functionality of these product type is identical, brokers call them differently. I will speak about Zerodha's product types; if you trade with another broker, I ask you to identify the nomenclature.

NRML –NRML can be used to refer to a standard product type. This is used when you plan to purchase and hold futures.

You should remember that NRML does not provide any additional information about your trade length. It is possible to keep the contract until expiry, but it doesn't have information about the stoploss. You may suffer losses and continue to pump in required margins. Because of this lack of clarity, you are charged full margins by the broker's RMS system (i.e. SPAN and Exposure

If you plan to hold the futures position for multiple days, use NRML. You can also use NRML intraday.

Margin intraday square off (MIS).Zerodha’s MIS is an intraday product. All trades made as MIS product types will indicate that trades will only last for one day. It is not possible to select MIS for an order type and expect that the position will be carried forward to next day. The position must be cut by 3:20PM. If this fails, the RMS system will also do the same.

Because the product type is MIS the RMS system knows it's an intraday trade. This is a notch above NRML in terms information flow. The trader is only exposed to 1 day of volatility when it is intraday. The margin requirements are lower than the NRML margins.

Cover order CO - The concept of cover order (CO) is very simple. The cover order (CO), which is similar to MIS in that it's an intraday product, is the first. The CO provides additional information about stoploss. You will need to indicate the stoploss when you place a CO. CO contains both the important information and the stoploss.

  1. The trade's length, which is intraday
  2. The stoploss is the maximum loss that you can bear in the event of a trade going against you.

Below is a snapshot of the CO buy form

The black area is where you must specify your stoploss. As we have done it through an article , in Z-connect, I won't get into the logistics.

This is something I want to remind you of: When you place a CO, you not only send that your trades are intraday but also the maximum loss you are willing and able to bear. This will cause margins to drop significantly (even lower than the MIS).

Bracket Order - This bracket order can be used in many ways. The BO can be considered an improvisation of the cover order. A BO is an intraday ordeal, so all BO orders must be placed by 3:20 PM. You will need to include a few additional details when placing a BO.

  1. Stoploss - Where you want to exit the trade in the event that the trade turns against you
  2. The Trailing stoploss is an optional feature that allows you to trail your stoploss. The trailing stoploss has not been discussed in this chapter. The same topic will be covered in the next chapter. For now, however, keep in mind that the BO allows you to trail your stoploss. This is actually one of the most common features of a BO.
  3. Target - The BO requires that you specify the price at the BO you wish to book the profits if the trade is in your favor.

The BO will send your order to the exchange. There you can also specify the target and stoploss. It is a great relief for active traders, as it assists them in many ways.

Below is a snapshot of the BO order form. The green box highlights SL placements.

The Bracket Order is the same information that the CO conveys to the RMS system. The BO also allows the trader to communicate the target price. What difference does the target price information make to the RMS? It doesn't make any difference from a risk management perspective. Remember that the RMS cares only about your risk, not your reward. The margin for BO and CO are the same.

We'll keep this discussion in perspective, and we'll look at some other options on Zerodha’s margin calculator.

7.3 - Return to the Margin Calculator

Let's recap briefly: In the previous chapter, Zerodha introduced Zerodha’s margin calculator. The margin calculator's purpose is simple. The margin calculator helps trader determine how much margin is needed for the contract they wish to trade. We also learned about rollover, expiry, and spread margins in our quest to understand this system. This chapter will help you understand the information flow to RMS and how it affects the applicable margins. These are important to remember. Let's now look at the two other options highlighted in red on the margin calculator: "Equity Futures", and "BO&CO". These features are highlighted in this snapshot:
Equity Futures The equity futures section of the margin calculator is a handy tool that helps traders understand the following:

  1. The NRML margin that is required for a specific contract
  2. The MIS margin required to sign a contract
  3. The amount of lots a trader is able to buy for the money he has in his trading account

As of January 2015, the Equity Futures section contained nearly 475 contracts. Let's take a look at some tasks to help us understand the situation better. These tasks will be solved using the Equity Futures section in the margin calculator. Hopefully, this will help you to understand the section.

Task 1 A trader has Rs.80,000/– in his trading account. He would like to purchase ACC Cements Limited Futures that expire 26 th February 2015, and keep the same for three trading sessions. This contract has a margin requirement. What margin is required to trade Infosys January Futures intraday? Is he able to open both trades with sufficient margin?

Solution – Let's start with the ACC futures. We need to search for NRML margins, as the trader plans to keep the futures contract open for three working days. This task can also be accomplished by using the SPAN calculator. This was discussed in the previous chapter. The Equity Futures calculator offers a few advantages over a SPAN.

You can view all contacts in the Equity Futures section. Scroll down until you find the contract you are looking for. The same contract has been highlighted in green. Notice how the calculator lists the contract's expiry dates, lot size, as well as the trading price.

The vertical black box highlights the NRML margins for each contract.

The table clearly shows that the ACC February 2015 needs a margin of Rs.48686/-.

To find Infosys' margin requirements, scroll down until you see Infosys January contracts. Or type "Infy” in the search box.

As we can see, Infy's NRML margin is Rs.67,698/-(highlighted in the black arrow), and MIS margin is Rs.27,079/-(highlighted in the red arrow). The MIS margin amount is significantly lower than the NRML margin.

The trader can select MIS product type because it is intraday. This allows him to enjoy a lower margin requirement of Rs.27,079/. Note that intraday trades can be made using NRML product types. It is not a problem. However, if one does this, the NRML Margin amount is blocked. It makes sense to choose MIS if you are clear about intraday trades and how to efficiently use capital.

However, the total margin requirement for trader would be -

  1. 48,686/$ towards the ACC contract (NRML Margin as the trader desires to keep the position for three days)
  2. 27,079/$ towards the Infosys contract, MIS margins because it is an intraday product.
  3. Margin of Rs.75765/- (48.686 + 27799)

The trader can open both trades if he has Rs.80,000/= in his account.

Task 2 A trader has Rs.120,000/– in his trading account. What number of lots of Wipro January Futures could he purchase on both an intraday and multiple-day basis?

Solution Search Wipro in the provided search box. Click on the "Calculate” button (highlighted with a green arrow) next to the MIS margin column. Click the same.

Once you click it, a form window will open up. You need to enter.

  1. The amount of cash in your trading accounts (defaultly set at Rs.100,000. You can change this to suit your needs.
  2. The current price at which the contract is traded (in reality, this is pre-populated).

Take a look at this screenshot -

Calculator suggests that I could trade up to three lots of Wipro futures using the NRML product category, given that the NRML margin per lot is Rs.36.806/-. The MIS product type allows me to trade up 8 lots considering that the margin requirement for each lot is only Rs.14722/-

Now we are familiar with all of the Equity Futures sections of the margin calculator's functions. Now we will move on to the BO&CO calculator.

7.4 - BO&CO Margin Calculator

For reasons we have already discussed, both cover order and bracket order have the same margin requirements. The BO&CO calculator is very simple and is similar to the SPAN. The following snapshot shows me trying to calculate the margin requirement of Biocon Futures that expire in February 2015. Notice that I have chosen everything I need, except the stoploss.

I press the "calculate" button without selecting the stoploss. The calculator will calculate the default stoploss and margin that can be chosen. The calculator will calculate the amount shown below, once I have mentioned the stop loss.

According to the BO&CO calculator the stoploss can be set at Rs.403. You can adjust the stoploss at any point and the margins will also change. The margin required to make a profit is Rs.9 062/-. This is remarkably less than the NRML margin (Rs.26,135/) and MIS margin (Rs.11,545.

7.5 - The trailing Stoploss

Let's briefly talk about the 'trailing limitloss' before we close this chapter. Trailing stoploss is a concept that can be used in bracket orders. It also plays an important role in trading. It is therefore important to be able to trail your stoploss. This is how most people would see it: You buy a stock at Rs.250 with the expectation that the stock will reach Rs.270 sooner than later. Keep a stoploss of Rs.240 in case something happens and you hope for the best.

The stock rises from Rs.250 and Rs.265 (just few Rupees from your target of Rs.270), but market volatility causes it to reverse course...all the way back to your stoploss at R.240. In essence, profits were seen for a short time but you had to cancel them. How can you handle such a situation. We are often placed in a situation where we know the direction and are able to adjust to market volatility.

You can avoid this by using the technique of "trailing" your stop loss. Trailing your stoploss can sometimes give you better chances of making more than you initially thought.

It is simple to adjust the trailing stoploss based on stock movement. The stoploss can be adjusted based on stock movement. Let me show you an example. This is an example of a trade setup.

Type of tradeLong
Futures priceRs.2175/ -
TargetRs.2220/ -
StoplossRs.2150/ -
RisquesRs.25 (2175-2150)
RewardRs.45 (2220-2175)

The idea is to trade long at Rs.2175 with a stoploss of Rs.2150. It is important to adjust the stoploss when the price changes in the trade direction. The SL can be adjusted for each 15 points in price movement. You can adjust the SL to any level in order to lock in profits. It is known as "Trailing Stop Loss" when you adjust the SL to lock in the profits. You might notice that I chose to randomly choose a 15-point move in this example. However, in reality it could be any price movement. Take a look at the table below. If the price moves 15 percent in my favor, I trail my SL to lock in a certain profit.

The original price target for the stock was Rs.2220. However, the trailing SL technique allows me to ride the momentum and make a greater profit.

  To Summarize

  1. The margin requirement is lower the more information one gives to the RMS system about trade duration and stoploss.
  2. When you need to trade or carry an item overnight, use the NRML product type.
  3. The highest NRML margins (SPAN + Exposure),
  4. MIS is an intraday trade. Consequently, the MIS margin will be lower than the NRML margin.
  5. An MIS trade only transmits time information (intraday), but not information about the stoploss
  6. Cover orders (COs) are also intraday products. In a CO one must specify the stoploss.
  7. A CO communicates both the time information and the SL information. Margins are therefore lower than MIS.
  8. A Bracket Order (BO), has margins similar to a CO.
  9. BO product types allow you to specify both the target price and the SL at once. You can also track the stop loss.
  10. You will need to adjust the SL when the script favors the trade.
  11. Trailing SL can be a great way for you to keep the momentum going in a script.
  12. There are no set trailing rules. One can choose to follow the market's lead.