Futures trading is dominated by margins, which allow one to leverage. Margin is the key to a futures agreement's financial success (as opposed to a spot market transaction). Understanding the margins and all aspects of margins is crucial.
Before we move on, however, let's make a list of the things you need to know. These are the concepts we have learned over the previous 4 chapters. Reiterating the key takeaways will help consolidate all our learning. You can review the previous chapters to refresh your understanding if you are unsure about any of these points.
If you understand all the points above, I would assume that you are on the right path. To clarify any of the points above, please refer to the four previous chapters.
Assuming you have understood the basics, let's now discuss margins and mark-to-market.
Let's now go back to chapter 1 and the forwards market example. The example above shows that ABC Jewelers will buy 15Kgs Gold from XYZ Gold dealers for Rs.2450/gram in 3 months.
Now we can see that any variation in the price of gold will have a negative impact on XYZ or ABC. If the price rises for gold, XYZ will suffer a loss while ABC will make a profit. Similarly, if gold prices drop, ABC loses and XYZ profits. We also know that forwards agreements are based on the gentleman's word. Imagine a situation in which the gold price has risen dramatically, putting XYZ Gold Dealers into a difficult position. XYZ could declare insolvent and default on the deal. The legal process that follows is going to be long and difficult, but it's not our area of focus. It is important to note that a forwards agreement has a very large scope and high incentive to default.
The futures market is an improvisation of the forwards market. This default angle must be carefully and intelligently managed. Here is where margins come in.
There is no regulator in the forwards market. There is no regulator in the forwards market. The agreement is between two parties. All trades in the futures market are routed through an exchange. In return, the exchange takes on the responsibility of settling all trades. The exchange has the responsibility of guaranteeing that you receive your money if you are entitled. They also ensure that they get the money from the party responsible for paying.
How does the exchange ensure that this happens seamlessly? They do this by using -
In the previous chapter, we briefly discussed the concept of Margin. To fully appreciate futures trading dynamics, you must be able to understand both M2M and Margin. It is hard to explain both concepts simultaneously so I will pause briefly on margins before moving to M2M. We will then fully understand M2M and return to margins. Then, we will reexamine margins while keeping M2M in view. Before we get to M2M, however, I want you to remember the following points.
For now, keep these points in mind. We will continue to explore M2M and then return to margins to finish this chapter.
We all know that the futures market fluctuates every day, so you can either make a profit or lose money. Marking to Market (M2M), also known as mark to market, is an accounting procedure that adjusts the profit or loss for the day. It entitles you to the same. M2M applies as long as the futures contract is in your possession. Let's look at a simple example.
Let's say you are deciding to purchase Hindalco Futures at Rs.165/. The Lot size is 2000. You decide to take the position at 2:15 PM at Rs.170.10/+ 4 days later on the 4th December 2014. This is clearly a profitable trade, as shown in the below calculation.
Purchase Price: Rs.165
Selling Price = Rs.170.1
Profit per share = (170.1-165) = Rs.5.1/
Total Profit = 2000 * 5.
The trade was however held for four working days. The profits and losses are marked to market for each day that the futures contract remains open. To calculate profit or loss, the closing price of the previous day is used as the reference rate.
|1st Dec 2014||168.3|
|2nd December 2014||172.4|
|3rd Dec 2014||171.6|
The above table shows the price movements of futures over the four days that the contract was in force. We will now look at the day-to-day activities of M2M to better understand its workings.
Day 1, the futures contract cost Rs.165/-. However, after contract purchase, the price of the contract has risen further to Rs.168.3/–. Profit for the day is Rs.168.3 minus Rs.165 = Rs.3.3/share. The lot size of 2000 means that the net profit for this day is 3.3*2000, or Rs.6600/.
The broker will ensure that Rs.6600/ is credited to your trading account at end of each day.
Here's another important point to remember: the futures buy price will no longer be Rs.165, but rather, it will now be Rs.168.3/- (closing prices of the day). You may be wondering why this is so. You have already received the profit for the day by crediting your trading account. You are now fair and square for today, and tomorrow is a new day. The buy price now stands at Rs. The closing price for the day is 168.3.
The futures ended at Rs.172.4/ - clearly another day of profit on day2. The day's profit would have been Rs.172.4/- less Rs.168.3/-, i.e. The profit per share would be Rs.4.1/- or Rs.8,200/ net. All profits you are entitled to are credited to your trading account and the buy price resets to the closing price of the day, i.e. 172.4/-
The day 3 futures ended at Rs.171.6/– which means that based on the previous day's closing price, there was a loss of Rs.1600/- (172.4 - 171.6 *2000 ). Your trading account will automatically debit the loss amount. The buy price has been reset to Rs.171.6/+.
Day 4 The trader decided to close the position at 2:15 PM at Rs.170.10/+. He also lost money on the previous day's close. This would result in a loss of Rs.171.6/– minus Rs.170.1/– = Rs.1.5/– per share and Rs.3000/– (1.5 * 2000). It is obvious that the squareoff does not affect the futures prices as long as the trader has resigned. The trading account is also debited with Rs.3000/ by the close of the day.
Let's just look at the daily mark-to-market value and see how much money has been inflow and outflow.
|Day||Ref Price M2M||Closing price||Daily M2M|
|1st Dec 2014||165||168.3||+ Rs. 6,600/-|
|2nd December 2014||168.3||172.4||+Rs.8,200/|
|3rd Dec 2014||172.4||171.6||-(Rs.1,600)/|
|4th Dec'14||171.6 and 170.1||169.9||-( Rs.3,000)/|
If you add all of the M2M cash flows, the sum will be the same as what we calculated originally, which is -
Purchase Price: Rs.165/-
Selling Price = Rs.170.1/ -
Profit per share = (170.1-165) = Rs.5.1/
Total Profit = 2000 * 5.
The mark to market is a daily accounting adjustment that -
Why is M2M necessary? M2M can be described as a daily cash adjustment which reduces counterparty default risk.The M2M exchange ensures that both parties are fair and equal every day, as long as a trader has the contract.
Let's keep the M2M concept in mind. Now let us reexamine margins to see how trades evolve over time.
We will now look at margins with M2M in mind. The margins needed to open a futures trading are known as "Initial Margin" (IM). The contract value is the initial margin. We also know:
Initial Margin IM = SPAN Margin + Exposition Margin
Few financial intermediaries are involved in ensuring that a trader's futures trades (or any other trade) runs smoothly. The broker and the exchange are the two most prominent financial intermediaries.
The broker and exchange will both suffer financial consequences if the client fails to fulfill an obligation. If both financial intermediaries need to be protected against a client default, they should be adequately covered by a margin deposit.
This is actually how it works. 'SPAN Margin is the minimum required margins that are blocked per the exchange's mandate. 'Exposure Margin is the margin over and beyond the SPAN to protect against MTM losses. The exchange specifies both the SPAN and Exposure margin. The client must adhere to the initial margin requirement when initiating futures trades. The entire initial margin is blocked by the exchange (SPAN + Exposure).
SPAN Margin is the more important of the two margins. Failure to have this in your account will result in a penalty from exchange. SPAN margin must be maintained for as long as trader wants to keep his position open overnight/next morning. SPAN margin is sometimes also called the " Maintenance Margin".
How does an exchange determine the SPAN margin requirement of a futures contract? They use an advanced algorithm to calculate the SPAN marges daily. This algorithm uses the stock's volatility as one of its key inputs. Volatility is an important concept that we will cover in detail in the next module. Remember this: If volatility is expected increase, then the SPAN margin requirement will also rise.
The exposure margin, or an additional margin to the contract value, can vary between 4% and 5%.
Let's now look at futures trades, keeping in mind both margin and M2M perspectives. Below the trade details are given,
|Symbol||HDFC Bank Limited|
|Types of trade||Long|
|Date||10th Dec 2014|
|Get the best price||Shares: Rs.938.7/share|
|Date to Sell||19 Dec|
|Reduce the price||Shares: Rs.955/share|
|Contract Value||250*938.7 = Rs.234,675/|
|SPAN Margin||7.5% of CV = Rs.17.600/-|
|Margin for exp||5.0% of CV = Rs.11733/-|
|IM (SPAN + Exposure).||17600 + 11733 = Rs.29.334/-|
|P&L per share||Profit per share of Rs.16.3/ - (955 - 933.8)|
|Net Profit||250 * 16.3 = Rs.4,075/|
Zerodha offers a Margin calculator which clearly states the SPAN margin and Exposure margin requirements. We will talk more about the utility of this useful tool at a later stage.
Let's keep the above trade details in mind. We will now examine how M2M and margins play a role during the trade's life. Below is a table that shows how dynamic changes occur on a daily basis.
The table is not intimidating, so don't be afraid to look at it. Let's go through it day by day.
10th Dec 2014
The HDFC Bank futures contract was bought at Rs.938.7/+ sometime during the day. 250 lots were purchased. The contract value is therefore Rs.234,675/+. The box to the right shows that SPAN is 7.5% and Exposure is 5.5%. Thus, 12.5% of CV is used as margins (SPAN+ Exposure). This amounts to a total margin in excess of Rs.29.334/-. Also, the initial margin is the initial money that was blocked by a broker.
HDFC will close at 940 today. The CV now stands at Rs.235,000/– and the total margin requirement for HDFC is Rs.29.375/-. This is marginally more than the margin required at trade initiation. This money is not required by the client to be infused into his account. He is already covered by an M2M profit, Rs.325/- that will be credited to him.
Total cash balance of the trading account = Cash Balance + m2M
= Rs.29.334 + Rs.325
The cash balance is clearly higher than the total margin requirement at Rs.29375/-, so there is no problem. The reference rate for the next day's M2M has been set at Rs.940/+.
11th Dec 2014
The HDFC Bank dropped by Rs.1/– to Rs.939/– per share the next day, affecting the M2M by negative Rs.250/- This money is taken from the cash balance and will be credited back to the person who made it. The new cash balance will then be -
The new margin requirement has been calculated at Rs.29,344/+. The cash balance is clearly higher than the required margin; therefore, there is no reason to be concerned. The reference rate for the next day's M2M has been reset to Rs.939/.
12th Dec 2014
It's an interesting day. The futures price dropped by Rs.9/– bringing the price to Rs.930/– per share. The margin requirement drops to Rs.29.063/- at Rs.930/. The cash balance falls to Rs.27159/- due to an M2M loss of Rs.2250/ (244909 - 24250), which is less than the total margin requirement. Is the client required to inject additional funds if the cash balance falls below the total margin requirement? It's not.
Keep in mind that the SPAN Margin is between the Exposure margin and the SPAN Margin. The SPAN margin is the most sacred. As long as your SPAN Margin (or maintenance) is not less than the broker's, most brokers will allow you to keep your positions. They will contact you to ask you to bring in more cash if your cash balance drops below the maintenance margin. They will close the positions if they don't receive the required margin money. The " Margin call" is a call from a broker asking you to pay the necessary margin money. A margin call by your broker means that your cash balance is too low to continue the position.
Referring to the example, Rs.27159/- cash balance is higher than the SPAN margin (Rs.17.438 /-);), so there is no problem. The trading account is debited with the M2M loss, and the reference rate of the next day's Mo2M is reset at Rs.930/.
Now you should be able to see how M2M and margins work together. You will also be able to see how the exchange can effectively combat a potential default threat under the M2M and margins. The combination of margin and M2M is almost a foolproof way to prevent defaults.
Assuming that you have a good understanding of the dynamics of margins, M2M calculation, and the rest of the trade period, I will now cut through the remaining days to get to the final day of trade.
19th Dec 2014
The trader decides at 955 to cash out and close the trade. The previous day's closing rates, which are Rs.938, is the reference rate for M2M. The M2M profit is Rs.4250/= which is added to the Rs.29159/- previous day cash balance. Once the trader has completed it, the broker will release the final cash balance of Rs.33.409/- (Rs.29.159 + Rs.4250).
What about the overall P&L for the trade? There are several ways to calculate this.
Method 1 - Add all M2M's
P&L = Sum all M2M
= 325 – 250 – 2250 + 4775 – 4000 – 4000 – 2000 + 3250 + 43250
= Rs.4,075/ -
Method 2 - Cash Release
P&L = Final cash balance released by broker - Cash Blocked initially (initial margin).
= 33409- 29334
= Rs.4,075/ -
Method 3 - Contract Value
P&L = Final contract Value - Initial contract Value
Method 4 - Futures price
P&L = (Difference between the futures buy and sell price) * Lot Size
Buy Price = 938.7; Sell Price = 955, Lot Size = 250
= 16.3 *250
= Rs. Rs.
You can see that regardless of how you calculate it, the P&L value is the same.
Let's pretend for a moment that the trade was not shut down on December 19th, but rather, it was carried forward to the following day, which is the 20th of December. Let's also assume that HDFC Bank drops heavily at 20 December. This could result in a drop of 8%, pushing the price up to 880 from 955. What do you believe will happen? Can you answer these questions?
I hope that you are able to answer these questions and calculate them yourself. If not, here are the solutions.