Margin & Mark to Market – Futures Trading

Margin plays the most important role in futures trading. In fact, margin is what makes futures trading different from spot trading as it adds a whole new avenue of trading to it. That’s why we need to understand margin very deeply.

But before proceeding, let us once again repeat those things, which we have learned so far in the last four chapters.

• The futures market is a modified form of the forwards market.
• Futures agreements are usually made on the basis of forward agreements.
• Futures agreements can bring you financial benefits if you have a definite opinion about the forward direction of an asset’s price.
• The price of a futures agreement is linked to the spot market price of its underlying.
• For example, the price of TCS futures is linked to the spot market price of the underlying ie TCS share.
• The futures price moves with the spot price of the underlying.
• There is a different formula to calculate the price of futures.
• A futures agreement is a type of standard agreement with pre-determined conditions such as lot size and expiry.
• The minimum quantity required to buy or sell a futures contract is called lot size.
• Contract Value = Futures Price × Lot Size
• The last date till which you can keep this agreement with you is called the date of expiry.
• For entering into a futures agreement, you have to pay a small amount as margin which is only a percentage of the contract value.
• By paying a small amount as margin, we can also do big deals, thus there can be leverage here.
• When we enter into a futures agreement, we enter into a digital signing agreement in a manner and say that we will fulfill this agreement.
• A futures agreement can be a buy/sell. This means that you do not need to keep this agreement with you till the expiry.
• You can keep the futures agreement with you as long as your opinion does not change. The day you change your opinion about the price, you can exit the agreement.
• You can also hold a futures agreement for a few minutes and sell it for your own benefit.
• For example, you can buy Infosys at 9:15 for Rs.
• You can hold a futures contract for 1 day or 1 month (till expiry).
• Equity futures have a cash settlement.
• These deals are leveraged, so even a minor change in the underlying has a huge impact on the P&L.
• The more profit or loss the buyer makes, the more loss or gain is made by the seller.
• In futures transactions, money moves from one pocket to another, hence it is called “Zero Sum Game”.
• The higher the leverage, the higher the risk.
• The pay-off structure of a futures agreement is linear.
• The futures market is regulated by SEBI and till now there have been no incidents of counter party defaults in the futures market.

If you have understood all these things properly. So we go ahead and talk about margin and mark to market.

Why is margin charged?

For a more in-depth understanding of margins, let us once again return to our example with ABC Jewelers, which we discussed in Chapter 1. ABC Jewelers entered into an agreement to buy 15 kg of gold at Rs 2450 per gram after 3 months from XYZ Gold Dealers. Now we know that if there is any movement in the price of gold then ABC and XYZ will gain and the other will lose. Suppose the price of gold moves very high and XYZ becomes very difficult, then XYZ can say that it cannot complete the deal and defaults. This will be followed by a long period of court battle. But the point of work for us here is that defaulting in such a situation is quite an easy path. Since the futures market is also built on the basis of the forwards market, therefore, understanding this possibility of default, some important changes have been made here and margin has been given an important role.

There is no regulator in the forward market. The agreement is between two people or two parties and no third person has any knowledge of it. Whereas in the futures market, all the transactions take place on an exchange, the exchange guarantees their settlement. Meaning the exchange ensures that you get your money when the deal is completed. That’s why the exchange takes money from all the parties first.

How do exchanges do this and how do they ensure that all this happens smoothly? It happens-

• By Taking margin
• By keeping a record of the profit or loss that occurs every day, which is called mark to market or M2M
• It is important for you to understand the principle of margin and mark to market properly because only then you will be able to understand the working of this market properly. But explaining these two together is a bit difficult task, so first I want to explain to you Mark to Market i.e. M2M. To understand this you have to remember a few things.
• Margin money gets blocked in your trading account as soon as you take a position in the futures market
• The margin that is blocked is called the “Initial Margin” or opening margin.
• There are two parts of the initial margin, the SPAN margin and the exposure margin.
• Initial Margin = Span Margin + Exposure Margin (Initial Margin = SPAN Margin + Exposure Margin)
• The initial margin block remains in your trading account as long as you stay in that trade.
• The amount of initial margin varies from day to day as it depends on the price of the futures
• The initial margin is a fixed percentage of the contract value.
• Contract Value = Futures Price × Lot Size
• Lot size is fixed but futures price changes every day that means margin also changes every day
• Now let us go ahead and try to understand M2M.

Mark to Market (M2M – Mark to Market)

Because the price in the futures market changes every day, your profit or loss also changes every day. Mark to Market or M2M calculates and keeps your same profit or loss at the end of the day so that at the end of the day you can know how much loss or profit you have made. M2M goes on as long as you stay in the futures contract. Let us understand this with an example.

Suppose on 1st December 2014 at 11:30 you decided to buy Hindalco futures at ₹165. Its lot size is 2000. After 4 days i.e. on 4th December 2014 you square off your position at 2:15 and the price is ₹170. 10. In the calculation below, you will see how much you have benefited.

purchase price = 165

Selling price = 170.10

Profit per share = 170.1-165 = 5.1

Total profit = 2000 × 5.1

= 10,200/-

But the deal was for four days. So every day its advantage or disadvantage was being noted in M2M. To calculate M2M, the closing price of the previous day is used.

Date	Closing Price
1st Dec 2014	168.3
2nd Dec 2014	172.4
3rd Dec 2014	171.6
4th Dec 2014	169.9

Let us understand on the basis of this table what happened in M2M every day in the last 4 days?

The futures contract was bought at 11:30 on the first day when the price was ₹165. The price rose on the day of buying and the closing price stood at ₹168.3. That is, the profit of the day was ₹ 168.3 – ₹ 165 = Rs 3.3. Since the lot size here is 2000, the total profit will be 3.3 × 2000 = ₹6600.

Now the exchange will ensure that ₹6600 is credited to your trading account through the broker by evening.

But where is this money coming from?

Money is coming from your counterparty. Meaning the exchange has ensured that the counterparty gives you ₹6600 for his loss.

But how does the exchange ensure that the counter party gives this money?

For this it only uses the margin which was deposited at the very beginning of the transaction.

Now you have to pay attention to one more important thing here – to keep the accounts correct, now your purchase price will not be ₹ 165 but ₹ 168 because this is the closing price of that day. You may ask why is this so? This is because any profit earned on that day has already been sent to your trading account as Mark to Market (M2M). It also means that your accounting till this day has been completed. The next day will be a new day. Hence the next day’s price of ₹168.3 will be considered as the opening price which was the previous day’s closing price.

On the second day i.e. on the second day of the transaction, the futures closed at ₹ 172.4 i.e. it was the close price. It means that on this day also you made profit. The profit per share for this day will be ₹172.4 – ₹168.3 = ₹4.1 and the total profit is 2000×4.1 = ₹8800. Now this profit will also come in your trading account and now the price will be ₹ 172.4.

On the third day, the futures price closed at ₹ 171.6 i.e. against the previous day’s close price, you are incurring a loss of ₹ 1600 (172.4-171.6 = 0.8×2000= 1600) on this day. This amount will also be directly withdrawn from your trading account and now the new price will be ₹171.6.

On the 4th day you did not hold this position and you squared off your trade at ₹170.10 at 2.15 pm. That is, even on this day you did not gain but loss. ₹ 1.5 (171.6 – 170.1 = 1.5) and total loss of ₹ 3000 (1.5 × 2000). Any price change after that will not affect your account as you have already squared off your position. By the end of the day, ₹ 3000 will definitely be withdrawn from your trading account, which is your loss for that day.

Putting all these transactions in a table see how the Mark to Market (M2M) keeps on changing.

Date	price for M2M	closing price	Day’s M2M
1st Dec 2014	165	168.3	+ Rs.6,600/-
2nd Dec 2014	168.3	172.4	+Rs.8,200/-
3rd Dec 2014	172.4	171.6	-Rs.1,600/-
4th Dec 2014	171.6 & 170.1	169.9	– Rs.3,000/-
Total			+Rs.10,200/-

If you calculate it again, you will see that –

purchase price = 165

selling price = 170.1

Profit per share = (170.1 -165) = 5.1

Total profit = 2000 × 5.1

= Rs 10,200/-

So mark to market i.e. M2M is a method of daily accounting,

In which money either enters or leaves your trading account depending on the change in the price of futures.
To calculate the mark to market for each day, the closing price of the previous day is taken as the basis.

After all, what is the need for mark to market? Basically by paying the profit or loss amount every day through mark to market i.e. M2M, the exchange ensures that the risk of counterparty default in the market is minimized. This calculation from mark to market keeps on getting equal every day.

Now back to the margins once again.

Margins – Large Perspectives

Keeping in mind the mark to market, let’s look at the margin once. As we have discussed earlier that the margin that is deposited at the time of trading is called Initial Margin (IM) or Initial Margin. And it is a fixed percentage of the contract value. we also know

Initial Margin (IM) = SPAN Margin + Exposure Margin

As soon as you start any deal in the futures market, a lot of financial intermediaries ie financial intermediaries are engaged in the work, so that your every deal can be completed smoothly without any interruption. The two most important intermediaries are the exchange and the broker.

Now if you default in your deal, it will affect both the broker and the exchange. Margin is used to protect both of them from any loss.

The minimum margin or minimum margin fixed by the exchange is called span margin. After this, to avoid any loss in M2M, another amount is added as margin which is called exposure margin. Both these margins are decided by the exchange. That is why the initial margin has to be deposited for any futures deal. The entire initial margin (SPAN + exposure margin) is blocked by the exchange.

The span margin is the more important of these two margins. If the SPAN margin amount is not on your trading account, you may be subject to a penalty. You need to have a span margin to hold your trade or to maintain your position. That’s why the span margin is sometimes called the maintenance margin.

Now the question is, how is it decided that what should be the span margin for which stock? A method algorithm is used to calculate this margin every day. The volatility in that stock plays a very important role in deciding how much this margin will be. What is volatility, we will discuss in the next module. Now it is important to know that as volatility increases in a stock, so does its margin.

Exposure margin acts as an additional margin. It is usually between 4 and 5% of the contract value.

Now let’s look at a futures trade from a margin and M2M perspective.

Description	Explanation
Stock	HDFC Bank Limited
Type of trade	Long
buy date	10th Dec 2014
buy price	Rs.938.7/- per share
sale date	19th Dec
sell price	Rs.955/- per share
lot size	250
contract value	250*938.7 = Rs.234,675/-
SPAN margin	7.5% of CV = Rs.17,600/-
exposure margin	5.0% of CV = Rs.11,733/-
IM/ initial margin (SPAN + Exposure)	17600 + 11733 = Rs.29,334/-
Per-share P&L	per share Rs.16.3/- (955 – 938.7) profit
Total profit	250 * 16.3 = Rs.4,075/-

If you are trading through Angelone/ Zerodha or through any reputed broker then you would know that there is a margin calculator which gives the SPAN and the exposure margin separately for each transaction. We will discuss the need of this calculator in more detail later. Now, based on the futures trade information given above, let’s see how margin and M2M play a role in a single transaction. In the table below you will see how it changes every day.

The above table is very easy to understand. Now let’s see how it’s changing every day:

10 December 2014

The futures contract of HDFC Bank was bought on this day at a price of ₹ 938. Its lot size is 250. Hence the contract value is ₹234675/-. As we can see in the above box that its span margin is 7.5% and exposure margin is 5%. This means that 12.5% ​​(SPAN + Exposure) of the total contract value will be blocked as margin, which is ₹ 29334. Initial margin is also called initial cash blocked.

HDFC closes that day at ₹940 at ₹940 making the contract value ₹233000. So the total margin will be ₹29375 which is ₹47 more than the earlier margin. Now for this, the customer will not need to put any more margin money because his mark to market i.e. M2M profit is ₹ 325 which is more than this amount and this amount has come in the trading account.

Thus the total amount in the trading account = Cash Balance + M2M

= 29,334 + 325

= 29,659

It is clear that the balance amount is more than the margin amount i.e. ₹ 29375. So there is no problem here. The new base price for mark to market M2M for the next day will be ₹940.

11 December 2014

The next day the share price of HDFC Bank falls by ₹1 and reaches ₹939 per share. Due to this M2M also goes down by ₹250. Now this amount is deducted from the remaining cash balance and given to the one who has made this profit. Now save in account

= 29,659 -250

= 29,409

After this a new margin is created ₹29344/- still the amount remaining in the account is more than this margin amount so there is no problem and now the new price for M2M will be ₹939/-.

12 December 2014

There is a bit more volatility in the market on this day. In futures, HDFC’s price falls by ₹9 and the new price becomes ₹930 per share. According to the price of ₹ 930, now the margin is ₹ 29063/-. But there is an M2M loss of ₹ 2250. Due to which the account is saved ₹27159/- which is less than the margin requirement. Now since the amount in the account is less than the margin, the customer will have to add more money to the account. No. It’s not like that.

You must remember that the span margin is given more importance among the span and exposure margin. Most of the brokers give you the facility that you can hold your position if you have full span margin (maintenance margin). When the amount in your account falls short of the maintenance margin, then the broker tells you that you will have to add more money. If you do not enter your position, your position will be closed. When a broker makes such a call, it is called a margin call. If your broker is calling you and asking you to enter margin, it means that the amount in your account has gone down drastically.

According to our example now the new cash balance is ₹27159 which is more than the span margin ₹17438 so no problem as of now. M2M loss is debited from your account and the new price for M2M for the next day becomes ₹930/-.

You might even have started to get a little sense of the way M2M and margin work. It must also be understood that through these, the exchange protects against default situations as these two, margin and M2M together prevent any type of default from happening in the market.

Now that you understand all this, we move on to the final day of this deal.

19 December 2014

The share price of HDFC has reached ₹955 and now the trader decides that he will square off his deal and withdraw the money. To do this, based on the previous day’s closing price, the amount of his M2M comes to ₹ 938. In this way his M2M profit becomes ₹4250. This amount gets added to his previous day’s balance i.e. ₹ 29159. In this way, now a total of ₹ 33409 (29159 + 4250) is left in his account. As soon as he squares off this deal, this amount will come in his account.

Now let’s see what the P&L of this entire deal will look like. There are several ways to draw a P&L:

Method 1) – By adding all the M2M

P&L = Sum of all M2M

= 325 – 250 -2250 + 4750- 4000 – 2000 + 3250 + 4250

= ₹ 4075

Method 2) – Cash Release

P&L = Final Cash Refunded by Broker (Cash Release) – Initial Margin (Initially Blocked Margin)

= 33409 – 29334

= ₹ 4075

Method 3) – Contract Value

P&L = Final Contract Value – Opening Contract Value

= ₹ 238,750 – ₹ 234,675

= ₹ 4075

Method 4) – Futures Price

P&L = (Difference of Buy and Sell Price in Futures) × Lot Size

Purchase Price = 938.7

Selling price = 955

lot size = 250

= 16.3 × 250

= ₹4075

As you can see, whichever way you withdraw the P&L, the amount comes out to be the same.

An Interesting Example of a Margin Call

Let’s assume for the time being that this trade is not squared off on 19th December and the deal continues till 20th December. On that day i.e. December 20, HDFC Bank’s stock falls 8% due to which the price falls from ₹955 to ₹880. Now what will happen here? Try to answer the questions given below yourself.

• What will the P&L of M2M look like?
• What will be the effect on cash balance?
• What is the span and exposure margin required?
• What will the broker do?

I hope that you will find out the answers to these questions yourself, but if you do not know the answer to these questions, then I will tell you the answer.

M2M loss will be ₹18750 [ (955-880) ×250] . Cash balance as on 19th December was ₹33409/- from this M2M loss will be deducted and the amount will be ₹14659 (33409-18750).
Since the price has fallen the new contract value will be ₹220000 (250×880)
The span on this contract value will be = 7.5% × 220000 = 16500
Exposure Margin = 11000
Total Margin = 27500
Because here the cash balance(14659/-) is less than the span margin(16500/-) so the broker will give you a margin call and some brokers will even cut your position.

Highlights of this chapter

• When you trade in futures, you have to pay margin. This margin is blocked as long as your trade is held.
• The margin that your broker blocks at the time of initiating the transaction is called Initial Margin.
• Both the seller and the buyer need to deposit an initial margin for futures deals
• This accumulated margin acts as a leverage where you can make a big deal based on this small amount.
• M2M is an accounting system that shows each day’s gain or loss in your trading account.
• The closing price of the previous day is considered as the basis for M2M.
• Span margin is the margin which is charged on the instructions of the exchange whereas the exposure margin is the one which is charged by the broker as per his requirement.
• The rate of SPAN margin and exposure margin is determined by the exchange itself.
• The span margin is also known as the maintenance margin.
• If you want to stay in this deal and if your margin amount has gone below the span margin then you will have to deposit more money as margin again.
• Margin call is a call when the broker calls you and tells you that you need to put more amount for margin.