Understanding the "Futures Trading"

Lesson -> The Margin Calculator

6.1 - The Margin Calculator

We will continue our discussion about margins in the preceding chapter and now we will discuss the margin calculator. The margin calculator and a few other topics will be covered in the next two chapters.

Remember, the previous chapter covered the different types of margins needed to open a futures trading. Because margins are dependent on volatility, the margins can vary between future contracts. Volatility will be discussed in the next module. For now, keep in mind that volatility changes from one underwriting to the other; therefore, the margins can vary from one underlying. How do we find out what the margin requirements are for a specific contract? If you trade with Zerodha, you will have probably come across the "Margin Calculator".

Zerodha's margin calculator is a popular offering, and for good reason. It's easy to use, but has a sophisticated engine running in the background. This chapter will explain the margin calculator and the requirements for each contract. This topic will be re-examined when we move on to the next module, which will cover the options chapter. At that point we will fully understand Zerodha’s margarit calculator's versatility.

Let's take a hypothetical case in which one buys the futures contract from IDEA Cellular Limited. It expires on 29 January 2015. To initiate the trade, one must deposit the initial margin amount. The Initial Margin (IM), as we all know, is the sum of SPAN Margin and Exposure Margin. All you have to do to find the IM requirement is this:

Step 1 As you can see, there are many options (I have highlighted them in black). For now, however, we will focus on the two options referred to as 'SPAN and 'Equity Futures'. You will actually land on the SPAN Margin Calculator page by default, highlighted with red.

Step 2: The SPAN Margin Calculator consists of two main sections. Let us examine them -

There are 3 drop-down menu options in the red section. You can choose which exchange you want to operate by selecting the 'Exchange' dropdown. Choose -

  1. NFO is required if you want to trade Futures on NSE
  2. MCX if your goal is to trade commodity futures.
  3. CDS is required if you want to trade currency derivatives on NSE

Next, you will see the 'Product' dropdown. If you want to trade futures contracts, choose Futures, or select Options if your preference is to trade options. The third drop-down menu shows symbols that are available for all futures and options contracts. Choose the contract that you want to trade from this drop-down menu. IDEA Cellular Limited is our interest. It expires on 29 January Jan. Please see the image below.


Step 4 - After you have selected the futures contract, your Net Quantity will automatically be pre-populated to one lot. You will need to manually enter additional quantities if you want to trade more than one lot. In the image below you can see that the net quality changes to 2000 when I select the IDEA Futures contract. If I want to trade 3 lots, I will need to enter 6000 (22000 * 3). After that, click on "Radio" and choose either buy or sell, depending on your preference. Finally, click on "Add".


After you tell the SPAN calculator that it should add the margins, it'll do the same and give you the split between Exposure, SPAN and the total initial margin. This is depicted in the red box -


SPAN calculate suggests the following:

SPAN Margin = Rs.22.160/-

Exposure Margin = Rs.14.730/-

Initial Margin (SPAN + exp) = Rs. 36,890/-

This will tell you how much money it takes to start a futures trade on IDEA Cellular. It is that simple! Next is "Equity Futures", which is the next section of the margin calculator. The next chapter will cover the same. Let's first understand three topics: the Intraday order types, Spreads and Expiry. These topics will help us better understand the "Equity Futures” on the margin calculator.

6.2 - Expiry

We briefly explained what the "Expiry" of a futures contract is in the previous chapters. The contract's expiry is the end date beyond which it ceases to exist. This is what you should consider: If I purchase an IDEA Cellular Limited futures contract for 149/- and it expires on 29 th January 2015 with the expectation that it will reach 155, this simply means that this move up to 155 must occur by 29 th January 2015. I must book a loss if IDEA's price falls below 149 before expiry. IDEA futures prices may reach 155 on the 30th January 2015. This is a loss as the contract has expired. Simply put, if I purchase a futures contract it must move in my favor on or before the expiry date.

Is it necessary to be so rigid? Does it allow for flexibility beyond the expiry date? Let me show you.

The Central Government budget is expected to be released sometime in February 2015. This is more than a month away considering today is 19 Jan 2015. This budget is expected to be a success. I am optimistic that the budget will also benefit the manufacturing sector, especially in light of the "Make in India" campaign. This is why I am willing to place a bet that BharatForge, a major in manufacturing, will greatly benefit from the budget. To be more precise, I expect BharatForge to rally starting now and continuing through the budget rally (pre-budget rally). To take advantage of my directional view on BharatForge, I would like to buy its futures now. Take a look at this picture below -

BharatForge's January 2015 contracts trade at Rs.1022/–, but here's an interesting situation: My view is that BharatForge would rally beginning now and continuing for the last week of February 2015. However, if I purchase the futures contract as shown above it will expire on 29 January 2015, leaving me halfway through.

Since my directional view extends beyond the January expiry date, I am not required to purchase the January expiry contract. NSE actually allows you to choose a contract that meets the expiry requirement for similar reasons.

NSE lets us buy futures contracts with three different expiries at any one time. We are currently in January, so we have three contracts with BharatForge with different expiry dates.

  1. 29th January 2015. This is the near-month contract or the current-month contract.
  2. 26th February 2015. This is the midmonth contract.
  3. 26th February 2015 - This is the fare month contract

Take a look at this image -

You can see that I have the option to choose from any contract in the expiry drop-down. This is based on what my requirements are. In this case, the mid-month contract expiring 26 February 2015 is my choice (as shown below).

The change in the futures price is one thing that stands out. The contract expires 26 th February 2015 and is trading at Rs.1,032/– while the contract expiring 29 _th January is trading at Rs.1,022.8/–. This means that the mid-month contract will be more expensive than the current month's contract. This is a general rule: the longer the expiry date, the more expensive the contract. As I write this, Bharat Forge Limited's March contract expires on 29 March 2015. It is currently trading at Rs.1,037.4/=.

Remember this: The current month's futures price should not be greater than the mid-month price. This should be lower than the far-month futures prices. This is because there is a mathematical explanation for it; we will discuss the futures pricing formula.

Here is another important concept to keep in mind: As I mentioned earlier, the NSE ensures that there are three futures contracts available at any given time (current, mid and far months). We know that the Bharat Forge contract will expire on 29 January 2015. The January contract can still be traded until 3:30 PM on the 29th of January 2015. After that, it will cease to exist. What does this mean? The January contract will be removed from the system, leaving only the February and March contracts.

It's not true. The January contract will be available until 3:30 PM on January 29 th 2015. After that, it will expire. NSE will announce the April 2015 contract at 9:15 am 30 January 2015. We will now have three contracts starting on the 30th January.

  1. From the mid-month contract to the previous day, the February contract would be deemed the current month contract.
  2. The March contract will now be considered the mid month contract (graduating from the far-month the previous day to a middle-month now).
  3. The far month contract is the April contract.

NSE will also introduce the May contract when the February contract expires. The market will therefore have March, April and May contracts to trade. And so on.

Assuming that I am continuing to use the Bharat Forge Limited futures contracts example, since I have a slightly longer term view, I could buy the futures contract expiring 26 February 2015, and then hold the February contract until I feel it is appropriate. There is an alternative. Instead of buying the February contract I can purchase the January contract and keep it until expiry or very close to expiry. I can buy the February contract by squaring the January contract. This is known as a'Rollover'.

You may notice that the business news anchor often talks about the "rollover data" around expiry time. This is not complicated at all. These numbers are intended to show how many traders have 'rolled' (or carried) their positions from the current month to mid-month. It is bullish if traders are rolling their long positions over to the next months. Conversely, bearish if traders are moving their short positions over to the next monthly. It's that simple. Is this a reliable technique to draw inferences about markets? It is not a proven technique to draw any concrete inferences about the markets.

In what situations would you choose to rollover rather than purchase a futures contract with a long term date? This is due to the ease of selling and buying, also known as 'The liquidity. Simply put, traders prefer to trade the current month contract at any given time to the far or mid-month contract. It is obvious that buying and selling becomes easier when there are more traders trading the same contract.

6.3 Sneak Peek at Spreads 

Now we are at an exciting stage. Some of the information below may seem confusing. However, you should still read it and try to understand as much as possible. We will discuss this further in the future.

These are just two examples of contracts.

  1. Bharat Forge Limited futures expires on 29 January 2015.
  2. Bharat Forge Limited futures expires on 26 th Feb 2015

These are two contracts that are priced slightly differently, but they can be considered to be one and the same contract. Both have the same underlying, i.e. Bharat Forge Limited has made both behave exactly the same. If BharatForge stock price on the spot market rises, then both February futures and January futures prices will go up. If Bharat Forge stock prices in the spot market go down, then both February futures and January futures prices would fall.

Sometimes, it is possible to make money by simultaneously purchasing the current month contract and then selling the mid-month contract. These opportunities are known as 'Calendar Spreads'. This is another topic. This will be discussed soon. However, I would like to bring your attention to the margins aspect.

We understand why margins are charged, primarily from a risk management perspective. How much risk is there if we buy the contract and then sell it? This reduces the risk dramatically. This is illustrated by numbers.

Scenario 1: Trader purchases only Bharat Forge Limited January Futures.

Bharat Forge's Spot Price = Rs.1021/- each share

Bharat Forge's January Contract Price = Rs.1023/- per Share

Lot Size: 250

Assume that the spot price drops from Rs.1011/- to after you have bought. (A 10 point drop).

Approximate futures price = Rs.1013/-

P&L = (10 * 250) = Rs.2500/- loss

Scenario 2: Trader buys January Futures and then sells them February Futures.

Bharat Forge's Spot Price = Rs.1021/- each share

Long on BharatForge's January contract at Rs.1023/ each share

Bharat Forge February contract - Rs.1033/- each Share

Lot Size: 250

Assume that the spot price falls to 1011 after you have set up this trade (a 10 point drop).

The approximate price for January Futures is Rs.1013/-

The approximate price for February Futures is Rs.1023/-

P&L for January Contract = (10*250), = Rs.2500/loss

P&L for February Contract = 10*250 = Rs.2500/profit

Net P&L = 2500 + 2500 = 0.

Scenario 3: Trader buys February Futures and sells January.

Bharat Forge Spot Price = Rs.1021/- per share

Bharat Forge January contract - Rs.1023/- per Share

Long on BharatForge February contract at Rs.1033/per share

Lot Size: 250

Assume that the spot price rises to 1031 after you have set up this trade (10 points increase).

The approximate price for January Futures is Rs.1033/-

The approximate price for February Futures is Rs.1043/-

P&L for January Contract = (10*250), = Rs.2500/Loss

P&L for February Contract = (10*250)= Rs.2500/- Profit

Net P&L = 2500 + 2500 = 0.

The point I am trying to make is that if you have a long contract and a short contract, your risk is almost zero. It isn't completely risk-free. One must account for liquidity, volatility and execution risk. However, overall the risk decreases dramatically. When risk is reduced dramatically, margins should also decrease.

This is actually what happens. Take a look at these snapshots.

This is the margin requirement (Rs.37.362/-) for January contracts of BharatForge.

This is the margin requirement of Rs.37,629/= when we intend selling February contracts of BharatForge.

This is the margin requirement for February contracts of BharatForge.

You can see that the January and February contracts cost Rs.37.362/- and Rs.37.629/-, respectively. The total cost is Rs.74,991/=. The margin requirement is required when futures contracts are bought and sold simultaneously. The combined position, as you can see in the above image, requires a margin only of Rs.7213/- You can also look at it from Rs.74,991/=, Rs.67.658/=, i.e. Margin Benefit (highlighted black) is reduced and passed on to clients. Remember this: A simultaneous short and long position can only be created when there are opportunities. These opportunities are called the Calendar Spread. There is no need to trade if the calendar spread opportunity does not exist.

To Summarize

  1. Zerodha's Margin Calculator is an easy tool that allows you to calculate the margin required to enter a futures contract.
  2. Margin calculator comes with many features.
  3. The margin calculator calculates the split between the SPAN margin and the Exposure margin.
  4. NSE guarantees that there are at least three contracts with the same underlying at any one time. They expire on three different (but consecutively) months.
  5. The expiry date is what allows a trader to choose the contract that suits him best.
  6. The current month's contract is called a 'Current Month Contract,' the next month's contract is called a 'Mid Month Contract,' and the 3 last contract is called a 'Far Month Contract.
  7. The current month contract expires at the end of each month and a new far-month contract is created. The mid-month contract would then be converted to the current contract.
  8. Calendar spreads are a trading technique that involves simultaneously buying and selling a month's contract for the same underlying.
  9. Because of the reduced risk, margins are required for calendar spreads.