In this chapter, we will discuss a crucial concept related to futures – margin. We shall talk about how margins are charged when placing orders in the futures segment. We will then discuss a vital tool which you might have heard of – leverage. We shall also talk about a concept called marking-to-market and how it is calculated on a day-to-day basis. Given the importance of margin in futures trading, we urge readers to spend a good amount of time on this chapter to get a strong hang of the way margins function.
As we said in an earlier chapter, one of the major factors that led to the emergence of futures was the existence of default risk in forwards. Because forwards are private contracts, there were risks of one of the counterparties to the transaction defaulting on their obligation of fulfilling the contract. In order to mitigate such risks, standardized exchange-traded futures contracts started gaining prominence in the late-1950s when they were first introduced on the CBoT. But how exactly do futures help in mitigating the risk of defaults? Let us now understand more about this using a simple example.
Let us first start with forwards. One of the reasons why forwards face default risk is because of the way several forward contracts are structured (although this has changed for the better since the 2008 Global Financial Crisis). For instance, when a forward contract is first entered into, there is no exchange of money and asset. Instead, this exchange occurs on the maturity date. The buyer of the forward contract must make full payment to the seller of the forward contract, who in turn will then deliver the underlying asset to the buyer. But what if the price of the underlying has moved quite a bit from the date of entering into the contract till the date of maturity, making the transaction unfavourable to one of the party? For instance, let us assume that ABC and XYZ enter into a 3-month forward contract, wherein ABC would be buying an asset from XYZ, 3 months down the line at today’s prevailing price of ₹100. At the time of entering into the contract, there is no exchange of money and asset. Instead, everything would be done on the maturity date. What if three months have passed and the price of the asset now is ₹80? In this case, ABC would be at a disadvantage because he is obliged to buy the asset from XYZ at ₹100, while the prevailing market price is ₹80. Because of this disadvantage, ABC might default on fulfilling his payment obligation and instead buy the asset directly from the market. Clearly, XYZ would suffer in this case.
Futures contracts that are traded on exchanges, however, do not face such risks. What steps do the exchanges take to prevent either parties from defaulting? Let us talk more about this now. To prevent defaults, exchanges charge margin at two levels. The first is when a trader wants to create a new position (buy/sell) in a futures contract. At the time of entering into a futures position (long or short), the trader has to deposit InitialMargin with his/her broker. ThisInitial Margin is usually a certain percent of the total value of the futures contract. If a trader does not have the required Initial Margin in his/her trading account, he/she won’t be able to take a position in futures. Meanwhile, once the position has been initiated, the Initial Margin gets blocked and is not released until the time the position is squared off. In other words, as long as the position is not closed, the trader will not be able to use this margin for any other purpose. The second is charged at the end of each session and is called the Marking-to-Market margin. In this case, the profit/loss for each session is adjusted into the trader’s account at the end of that session on the basis of the Daily Settlement Price (DSP). For instance, if the trader has earned a profit for the day, that profit would be credited into his/her trading account; and if the trader has incurred a loss, that loss would be debited from his/her account.
This way, by charging and blocking the Initial Margin until the time the trader closes out his/her open position and by Marking-to-Market the trader’s account at the end of each session rather than at the time of contract maturity, the exchange ensures that none of the counterparties to the futures trade back-off from honouring their contracts in case they are in a loss-making position. The entity that is entrusted with ensuring there are no defaults or counterparty risk is called the Clearing House, which acts as an intermediary between the buyer and the seller.
As we stated earlier, there are two types of margins that are levied by the exchange. The first is the Initial Margin, which is levied and blocked when entering into a futures contract. The next is the Marking-to-Market Margin, which is levied each day until the time the futures contract is held onto or expires. In this section, we will talk in detail about Initial Margin.
As stated earlier, Initial Margin is a margin that a trader needs to have in his/her trading account at the time of entering into a futures contract. You can think of Initial Margin in futures as a deposit that a landlord would collect from his/her tenant at the time of signing the rental agreement. As long as the contract is in force, the deposit stays with the landlord. The deposit ensures that the tenant does not default when it comes to rent payment. Coming back to our topic of discussion, the Initial Margin ensures that none of the parties to the futures trade run away without honouring the contract.
Initial Margin comprises of two components - SPAN Margin and Exposure Margin. Put it in the form of an equation, Initial Margin can be expressed as:
Initial Margin = SPAN Margin + Exposure Margin
SPANMargin, which is also referred to as VAR (Value at Risk) Margin, is a widely usedglobal method for calculating margin requirements based on the worst possible move that could reasonably be expected to occur over a given time frame. In the Indian context, SPAN margin is intended to cover the largest possible loss that a portfolio might suffer from one day to the next. To gain further insights on NSE SPAN Margin and its computation, one could refer to the requisite page of NSE by clicking here.The calculation of SPAN Margin is quite complex. The good news is that we do not have to perform these complex set of calculations as the same are performed by the exchange on a day-to-day basis. For futures contracts that are traded on the NSE, the exchange itself specifies the SPAN margin for each trading session. In fact, depending on parameters such as volatility, the SPAN Margin keeps changing.Meanwhile, SPAN Margin varies depending on the futures instrument in question. Volatility has a major say in determining the SPAN Margin requirement for futures that are traded on an exchange. As a rule of thumb, the greater the volatility, the greater will be the SPAN Margin, and vice versa. Because index futures tend to exhibit lower volatility than stock futures, they have a lower SPAN Margin requirement than stock futures.
Exposure Margin, which is also referred to as additional margin, is the margin that is charged on top of the SPAN Margin. The Exposure Margin acts as an additional layer of safety to the broker over the Initial Margin. Exposure Margin is usually set as a certain percent of the total contract value. On the NSE, for index futures, exposure margin is 3% of total contract value; while for stock futures, exposure margin is 5% or 1.5 standard deviation of the total contract value.
SPAN Margin + Exposure Margin
As stated in the above equation, Initial Margin is arrived at by summing the SPAN Margin and the Exposure Margin. To read more about Initial Margin that the NSE levies, one could refer to the requisite page of NSE by clicking here. It is crucial to keep in mind that Initial Margin is the minimum margin a trader must maintain in his/her trading account if he/she intends to carry an overnight position in futures or hold it till expiry. This is standard across all brokers. Even after such a position (overnight) has been initiated and carried over to the next day, the trader’s margin account musthave funds equivalent to the Initial Margin of the open position(s). If the balance in the trader’s margin account falls below the level of the Initial Margin of his/her open position(s), the trader would get a call from his/her broker to top up to the level of InitialMargin, failing which the broker can exit the open position(s) of the trader. Furthermore, overnight positions that are held without adequate margin in the trading account would be subject to penalties imposed by the exchange. To read more on such penalties, one could refer to the requisite page of NSE by clicking here.
Irrespective of whether the position is intraday or overnight, the initial margin remains the same. However, because the risk involved in creating an intraday position is smaller than that involved in creating an overnight position, brokers tend to give greater leverage for intraday positions. Keep in mind that an intraday position is one that is created and exited on the same day, while an overnight position is one that is created today but carried forward to the subsequent day(s).
Now that we understand the concept of Initial Margin, SPAN Margin, and Exposure Margin, let us put theory into practice. Let us look at how the margins are levied when opening a futures position, wherein the trader intends to carry the position overnight.
Let us take the example of Nifty futures, expiring on July 30th, 2020. At the time of writing, the price of the said contract is 10289. Given the lot size of 75, the total contract value comes to ₹7,71,675 (10289 * 75). On our FYERS website, we have a margin calculator, which calculates the margin needed to carry forward a futures position. We will talk about the FYERS Margin Calculator in greater detail later in this module. For now, just keep in mind that to create an overnight long position in the said contract, the Initial Margin needed is ₹1,42,873. Out of this, the SPAN Margin is ₹1,27,439 and the Exposure Margin is ₹15,434. Calculating each as a percent of total contract value, we get:
SPAN Margin = 16.51%
Exposure Margin = 2.00%
Initial Margin = 18.51%
Let us take another example, now of Reliance futures, expiring on July 30th, 2020. At the time of writing, the price of the said contract is 1753. Given the lot size of 505, the total contract value comes to ₹8,85,265 (1753 * 505). Visiting out FYERS Margin Calculator again, we see that to create an overnight long position in the said contract would require an Initial Margin of ₹2,45,978. Out of this, the SPAN Margin is ₹2,14,994 and the Exposure Margin is ₹30,984. Calculating each as a percent of total contract value, we get:
SPAN Margin = 24.29%
Exposure Margin = 3.50%
Initial Margin = 27.79%
Looking at the above two examples, we see that stock futures require a greater initial margin than index futures. This makes sense, given that stocks exhibit greater volatility than indices. And as stated earlier in this chapter, the greater the volatility, the greater will be the margin, and vice versa.
Also, another thing to observe from the above two examples is that to take a long position in Nifty July futures contract, just a little under 20% of the total contract value is needed in the margin account. With ₹1,42,873 in the margin account, the trader is able to take a long exposure in Nifty futures to the tune of ₹7,71,675. Similarly, to take a long position in Reliance July futures contract, just a little under 30% of the total contract value is needed in the margin account. With ₹2,45,978 in the margin account, the trader is able to take a long exposure in Reliance futures to the tune of ₹8,85,265.This is called leverage. Let us now discuss more about this in the next section.
One of the reasons why futures attract a lot of interest from traders is because of the immense leverage that these instruments offer. Let us try explaining this using the above example of Reliance.
In the previous section, we saw that to take one long position in Reliance futures, the trader needs to have funds in his/her margin account to the tune of the Initial Margin only rather than the entire contract value. With thisInitial Margin, the trader is able to control the position that is much larger. Let us compare this to creating a position in the cash segment.
Buy 1 lot of Reliance futures at CMP 1753
Initial Margin needed at present = ₹2,45,978
Lot size = 505
Let us assume that in 10 sessions, the price of Reliance futures has rallied from 1753 to 1900. In this case, as the trader is long Reliance futures, he would realize a profit. The profit realized can be calculated as [(New price – Old price) * Lot size * Number of lots]. This turns out to be ₹74,235 [(1900 - 1753) * 505 * 1].
Instead of buying 1 lot in futures, which would require a margin of ₹2,45,978, what if the trader instead chose to deploy the same amount of money for buying shares of Reliance from the cash segment? At the prevailing Reliance cash price of 1746 and a capital of ₹2,45,978, the total number of shares that the trader can buy is equal to 141 (245978 ÷ 1746).
Considering the same situation as above, let us assume that in 10 sessions, the price of Reliance cash has rallied from 1746 to 1895. In this case, as the trader is long Reliance in cash segment, he would realize a profit. The profit realized can be calculated as [(New price – Old price) * Number of shares long]. This turns out to be ₹21,009 [(1895 - 1746) * 141].
As we can see from the above two examples, for the same amount of capital deployed (₹2,45,978), the trader has realized a profit of ₹74,235 in the futures position and a profit of ₹21,009 in the cash position. In percentage terms, the return turns out to be 30.1% in case of futures position and 8.5% in case of cash position. Notice the difference?The additional profit that is generated in the futures segment is because of leverage. Leverage in the futures segment allows traders to control a much bigger position than the capital deployed, thereby amplifying the profit potential in case the view of the trader goes right. But notice the condition attached to this – in case the view of the trader goes right. What if the view of the trader goes wrong?
Let us consider the same example as above. But in this case, let us assume that in 10 sessions, the futures price has declined from 1753 to 1600, while the cash price has declined from 1746 to 1595. In this case, had the trader initiated a long position in Reliance futures, assuming that he had sufficient margin in his trading account to hold on to such a position for 10 sessions, he would have suffered a loss. This loss would have amounted to ₹77,265 [(1600 - 1753) * 505 * 1]. On the other hand, had the trader created a long position in Reliance in the cash segment, his loss would have amounted to ₹21,291 [(1595 - 1746) * 141]. Observed the difference? While the capital deployed was the same, the loss in the futures position was much higher than the loss in the cash position. In percentage terms, the return in the futures position was -31.4% while that in the cash position was -8.6%.
What we can learn from the above example is that leverage can hurt a trader as much as it can benefit him/her. In case the view of the trader goes wrong, because of leverage, the losses in the futures position could amplify if the futures price goes against you by a big margin. Hence, one must be very careful when trading in the futures segment. Risk management is of utmost importance when it comes to creating and holding positions in the futures segment.
Once the Initial Margin has been blocked and a position has been created, the next margin that comes into picture is called the Marking-to-Market (MTM) Margin. This margin is adjusted at the end of each trading session on the basis of the Daily Settlement Price. Put it in simple words, MTM is the process of adjusting daily profits/losses at the end of each session. It is calculated by taking the difference between the current session’s settlement price and the prior session’s settlement price. In case the trader has realized a profit, the same would be credited to his/her trading account at the end of the session. On the other hand, if the trader has incurred a loss, the same would be debited from his/her trading account at the end of the session.
When a futures contract is first created and then carried overnight, the daily MTM for the first day is calculated as the difference between the trade price and that session’s settlement price. On the subsequent days, the daily MTM is calculated as the difference between the current trade day settlement price and the previous trade day settlement price. To understand more about the daily settlement mechanism of NSE equity derivatives, one could refer to the requisite page of NSE by clicking here. Let us now look at an example to understand how the daily settlement mechanism works. Let us continue with the same example of Reliance that we spoke earlier in this chapter.At the time of initiating the long position in Reliance, the futures price is 1753. Let us now see how the daily profits/losses are adjusted at the end of each day. For the sake of simplicity, let us assume that the trader has more than adequatefunds in his/her trading account to cover for the daily MTM:
|Session||Daily Settlement Price||Price Change||Profit/Loss Adjustment|
|1||1753 (Buy Price)||-||-|
|10||1900 (Sell Price)||+29||₹14,645|
In the above table, on day 1, the daily MTM is calculated as [(DSPT – buy price) * Lot size * Number of lots bought]. For each of the subsequent days that the position is carried forward, the daily MTM is calculated as [(DSPT – DSPT-1) * Lot size * Number of lots bought]. Similarly, on day 10, when the trader opted to close out his position and book profits, the daily MTM is calculated as [(Sell price – DSPT-1) * Lot size * Number of lots bought].
Notice that the end result is the same. That is, the total profit realized on this trade is ₹74,235 [(1900 - 1753) * 505 * 1]. If you observe in the table above, this is the exact figure that is arrived after adjusting the daily MTM for each of the past ten sessions. The only difference is that in case of daily MTM, the profits/losses get adjusted at the end of each session. Profits realized (represented by green figures in the table above) get credited into your trading account, while losses incurred (represented by red figures in the table above) get debited from your trading account. By Marking-to-Market the accounts daily rather than just at the time of position closure or contract expiry, the exchange ensures that there are no defaults or counterparty risks.
Now that we have a strong understanding of Initial Margin, Marking-to-Market Margin, and Leverage, let us take a full-fledged example. Let us continue with our example of Reliance. Below mentioned are the necessary data pertaining to the trade:
Name of the futures instrument = Reliance
Quantity = 1 lot
Lot size = 505 shares
CMP of the futures contract = 1753
Total Contract Value = ₹8,85,265 (1753 * 505)
Initial Margin = ₹2,45,978
SPAN Margin = ₹2,14,994
Exposure Margin = ₹30,984
Initial Margin as a % of Total Contract Value = 27.79
SPAN Margin as a % of Total Contract Value = 24.29
Exposure Margin as a % of Total Contract Value = 3.50
There will be changes in the Initial Margin percentages each day depending upon factors such as price change and volatility. However, for ease of calculation, let us keep each of the margin percentages mentioned above constant for each of the session that the position is held onto.
|Session||DSP||Price Change||Contract Value||Initial margin||SPAN Margin||Exposure Margin||Daily MTM||Closing Balance|
In the above table, notice that as the futures price changes, so does the contract value and subsequently the amount of Initial Margin. See that a rise in the futures price leads to an increase in Initial Margin, and vice versa. Please note that in the calculations above, we have assumed that the Initial Margin percent remains constant throughout. In the real world however, this percent is not static and is defined by the exchange every session. The most important thing to remember is that the balance in the trader’s account must be above the level of Initial Margin at all times. If it falls below the level of Initial Margin, the trader will get a call from his/her broker to bring the balance in his/her trading account back to the level of Initial Margin, failing which the broker has the right to exit the trade and debit the losses. Below mentioned are the details of the calculations done above:
Contract value for a session = DSP of that session * Lot size * Number of lots
Initial Margin for a session = Contract value for that session * 27.79%
SPAN Margin for a session = Contract value for that session * 24.29%
Exposure Margin for a session = Contract value for that session * 3.50%
Price Change for a session = Current session DSP – Prior session DSP
Daily MTM = Price Change * Lot Size * Number of lots
Closing Balance for a session = Closing Balance of the prior session + Daily MTM
Let us conclude this chapter by talking about some key points relating to margins:
When a futures position is created, funds in the client’s account get blocked to the extent of Initial Margin that is needed to open that position
The Initial Margin remains blocked as long as the position is held onto
Initial Margin does not remain static. As the futures price changes, so does the Initial Margin
The Initial Margin percent is defined by the exchange every session
A rise in futures price will increase the Initial Margin, and vice versa
MTM is adjusted at the end of each session, based on the Daily Settlement Price (DSP)
MTM is calculated as (current session settlement price less prior session settlement price) times the lot size times the number of lots
For long positions, a rise in DSP leads to profit, and vice versa
For short positions, a fall in DSP leads to profit, and vice versa
MTM profits realized in a day are credited into the client’s account, while losses are debited
Closing Balance for the day is the sum of the prior day balance and the Daily MTM
If profits are realized in a day, closing balance increases, and vice versa
Funds in a client’s trading account must not fall below the level of Initial Margin
If it does, the client will get a Margin Call from his/her broker to top up the account balance to the level of the Initial Margin
If the account balance is not bought back to the level of the Initial Margin, the broker has the right to close out the position and debit losses from the client’s account
Once the position is exited, all blocked funds are released
Futures Strategies – Part 115 Lessons
Over the next two chapters, we shall discuss various strategies involving futures. For our discussion, we will keep our universe restricted to index and stock futures that are traded on the NSE. The objective of this chapter and the next is to enable the reader to understand various strategies that can be deployed using futures. In this chapter, we shall focus on long futures, short futures, and Calendar Spread.
Futures Strategies – Part 219 Lessons
In this chapter, we shall continue with our discussion from the previous chapter and talk about the remaining futures strategies that we want to cover in this Module. The two strategies that we would be speaking in this chapter are Ratio Trading and Hedging.
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