Understanding the "Futures Trading"

Lesson -> The Margin & M2M

5.1 - Things that you should know now

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.

  1. Future is an improvisation of Forwards.
  2. Futures agreements inherit the transactional structure from the forwards market.
  3. If you have a clear directional view of the asset's price, a futures agreement can help you financially.
  4. Futures agreements derive their value from the spot market's corresponding underlying.
    1. TCS Futures, for example, derives its value in the TCS Spot Market underlying.
  5. The Futures price is the same as the spot market underlying price.
    1. Because of the futures pricing formula, the spot and futures prices of assets are different. This point will be discussed at a later stage of the module.
  6. Futures contracts are standardized contracts where the agreement variables (lot size, expiry date) are predetermined.
    1. The minimum amount specified in the futures contract is the lot size.
    2. Contract value = Futures Price * Lot Size
    3. The expiry date is the end of a futures agreement.
  7. A margin amount equal to a certain percentage of the contract value is required in order to enter into a futures arrangement.
    1. Margins enable us to deposit small amounts of money but gain exposure to large-value transactions, thus leveraging the transaction.
  8. We digitally sign a futures contract when we transact; we are obligated to honor the contract after it expires.
  9. Futures agreements can be traded. This means that you don't have to hold onto the futures agreement until it expires.
    1. The futures contract can be held until you are convicted on the asset's direction view. Once your view has changed, you can exit the futures arrangement.
    2. You can even keep the futures agreement open for a few moments and still get financial benefits if the price changes in your favor
    3. One example would be to purchase Infosys Futures at 9:00 AM for 1951, and then sell it at 9:00 AM for 1953. Infosys lots are 250 in size, so one could make Rs.500/– (2 * 250) in just 2 minutes
    4. You have the option to keep it for several days, or to let it expire.
  10. Cash-settled equity futures contracts can be purchased
  11. A small change in the fundamental results in a huge impact on the P&L when leveraged
  12. The buyer makes the same amount as the seller, and vice versa.
  13. A futures Instrument is a way to transfer money from one account to another. It is  "Zero Sum Game".
  14. Higher leverage means higher risk
  15. A futures instrument's payoff structure is linear.
  16. The Securities and Exchange Board of India regulates the futures market. The futures market has not been affected by counterparty defaults thanks to SEBI's watchful eye.

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.

5.2 - What are Margins Charged?

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 -

  1. Collecting the margins
  2. Also known as M2M, this is the process of determining whether there are daily market profits or losses.

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.

  1. Margins in your trading account are blocked at the time you initiate the futures position.
  2. The "Initial Margin" is the blockage of margins.
  3. Two components make up the initial margin: The SPAN margin is different from the Exposure Margin.
  4. Initial Margin = SPAN Marin + Exposure Margin
  5. Your trading account will block the initial margin for as long as you hold the futures trade.
    1. The futures price and the value of the initial margin can have an impact on how much the initial margin is worth. Its value changes daily.
    2. Remember that the Initial Margin is % of the Contract Value
    3. Contract Value = Futures price * Lot Size
    4. While the lot size is set, the futures price fluctuates daily. The margins can also change daily.

For now, keep these points in mind. We will continue to explore M2M and then return to margins to finish this chapter.

5.3 - Mark To Market (M2M).

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.

= Rs.10,000.-

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.

DayClosing price
1st Dec 2014168.3
2nd December 2014172.4
3rd Dec 2014171.6
4th Dec'14169.9

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.

  1. But where does this money come from?
    1. It is evident that it comes from the counterparty. This means that the counterparty is also paying Rs.6600/= towards his loss
  2. How does the exchange make sure they get the money from the party that is supposed to pay?
    1. You can do this, naturally, by depositing the margins at the time you initiate the trade. More on this later.

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.

DayRef Price M2MClosing priceDaily M2M
1st Dec 2014165168.3+ Rs. 6,600/-
2nd December 2014168.3172.4+Rs.8,200/
3rd Dec 2014172.4171.6-(Rs.1,600)/
4th Dec'14171.6 and 170.1169.9-( 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.

= Rs.10,000.-

The mark to market is a daily accounting adjustment that -

  1. Based on the behavior of futures prices, money can be credited or debited (also known as a daily obligation).
  2. To calculate the current-day M2M, we take into account the previous day's close price.

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.

5.4 - The bigger perspective, the more margins

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,

ParticularMore Details
SymbolHDFC Bank Limited
Types of tradeLong
Date10th Dec 2014
Get the best priceShares: Rs.938.7/share
Date to Sell19 Dec
Reduce the priceShares: Rs.955/share
Lot Size250
Contract Value250*938.7 = Rs.234,675/
SPAN Margin7.5% of CV = Rs.17.600/-
Margin for exp5.0% of CV = Rs.11733/-
IM (SPAN + Exposure).17600 + 11733 = Rs.29.334/-
P&L per shareProfit per share of Rs.16.3/ - (955 - 933.8)
Net Profit250 * 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

= Rs.29.659/-

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 -

= 29659-250

= Rs.29.409/-

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

= Rs.238,750-Rs.234,675

=Rs.4,075/ -

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.

5.5 - A fascinating case of "Margin Call."

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?

  1. What is the M2M P&L and how does it work?
  2. What impact does this have on the cash balance?
  3. What is the SPAN or Exposure margin?
  4. What actions does the broker take to achieve this goal?

I hope that you are able to answer these questions and calculate them yourself. If not, here are the solutions.

  1. The M2M loss would amount to Rs.18.750/- = (955-880)*250. The 19 th December cash balance was Rs. 33,409/+, from which M2M loss will be deducted. This makes the cash balance Rs.14.659/- (Rs.33.409 - Rs.18.750).
  2. The new contract value, due to the drop in price, would be Rs.220,000/(250*880).
    1. SPAN = 7.5% x 220000 = Rs.16.500/-
    2. Exposure = Rs.11,000/ -
    3. Total Margin = Rs.27.500/-
  3. The cash balance (Rs.14.659/-), is lower than SPAN Margin(Rs.16.500 ), the broker will make a Margin call to the client or, in some cases, cut the position immediately if the cash balance falls below the SPAN requirement.

To Summarize

  1. As long as the futures trade remains live, a margin payment will be required. Your broker will block it.
  2. The initial margin is the amount of the margin that was blocked by the broker when the futures trade was initiated.
  3. Both the buyer or seller of the futures contract will need to deposit the initial margin amount.
  4. As leverage, the margin amount you collect allows you to deposit small amounts of money while being exposed to large-value transactions.
  5. M2M is an accounting adjustment that is simple. It involves debiting or crediting your trading account with daily obligation money based on the futures price.
  6. To calculate the M2M for the current day, we use the closing price of the previous day.
  7. SPAN Margin refers to the margin that is collected according to the exchanges instructions. Exposure Margin, on the other hand, is collected according the broker's requirements.
  8. The SPAN and Exposure Margin will be determined according to the exchange's norms.
  9. Commonly, the Maintenance Margin is referred to as SPAN Margin.
  10. If the SPAN is below the margin account, the investor will need to deposit more cash in his account if he wants to continue the future position.
  11. Margin calls are when the broker asks the trader for the necessary margin money if the cash balance falls below the required level.