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Margin & M2M

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Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

5. Margin & M2M

5.1 Things you should be aware of by now 

Margins undoubtedly play a significant part in futures trading because they provide for leverage. Margin is actually what provides a “Futures Agreement” the necessary financial twist (as compared to the spot market transaction). Therefore, it is crucial to comprehend margins and all of their varied aspects.

However, before we continue, let’s make a list of items you should be aware of by this point. These are ideas that we have learned during the previous four chapters; repeating these key points will help us integrate all we have learned. You must go back to the earlier chapters and review them if you are unclear about any of the following things.

  1. Over the Forwards is an improvisation called Future.
  2. The forwards market’s transactional framework is over into futures agreements.
  3. You can gain financially from a futures agreement if you have a precise sense of where the asset price is going.
  4. The comparable underlying in the spot market provides the futures agreement with its value.
  5. In the spot market, the underlying price is by the futures price.
  6. The lot size and expiration date of a futures contract, which is a standardised contract, have already been decided upon.
  1. The minimum quantity stipulated in the futures contract as the lot size.
  2. Value of the Contract = Futures Price * Lot Size
  3. Expiry is the final day on which a futures contract may be held.

7. One must deposit a margin amount equal to a specified percentage of the contract value in order to enter into a futures agreement.

1. Through the use of margins, we can leverage a transaction by making a little initial deposit and taking exposure to a transaction with a high value.

8. We digitally sign the contract with the counterparty when we transact in a futures transaction, obliging us to honor the deal at expiration.

9. The futures contract can be . Therefore, you are not  to keep the agreement until it expires.

  1. If your opinion of the asset’s direction changes, you can cancel the futures contract. You can retain the futures contract until you are of it.
  2. If the price changes in your favour, you can even hold the futures agreement for a short period of time and profit financially.
  3. Buying Infosys Futures at 9:15 AM for 1951 and selling them by 9:17 AM for 1953 would be an illustration of the aforementioned point. Given that the Infosys lot size is 250, one might earn Rs. 500 (2 * 250) in under two minutes.

  4. Even better, you can decide to keep it till it expires or cling onto it overnight for a few days.

10. Equity futures contracts settle in cash.

11. A modest change in the underlying has a significant impact on the P&L when there is leverage.

12. The buyer’s earnings are comparable to the seller’s losses, and vice versa.

13. Transferring money from one pocket to another is possible using futures instruments. As a result, it is  as a “Zero Sum Game.”
14. The risk increases as leverage increases.

15. A futures instrument’s payout structure is linear.

16. The Securities and Exchange Board of India regulates the futures market (SEBI). . There haven’t been any instances of counterparty default in the futures market because SEBI is keeping a close eye on things.

If you can clearly comprehend the previously given things, I’d say you’re currently headed in the right direction. You should go back and read the first four chapters again if you have any queries about any of the aforementioned things.

Anyway, if you understand up to this point, let’s concentrate more on the ideas of margins and mark to market.

5.2 – Why are Margins charged?

Let’s go back to the forward market scenario we used earlier (chapter 1). In the cited example, ABC Jewelers agrees to purchase 15 kg of gold from XYZ Gold Dealers for Rs. 2450 per gram in three months.

Now it is obvious that any change in the price of gold will negatively impact either ABC or XYZ. If the price of gold rises, ABC will profit and XYZ will lose money. Likewise, if the price of gold drops, ABC loses money while XYZ profits.

A forward agreement also relies on a gentleman’s word, as we all know. Imagine that the price of gold has significantly increased, putting XYZ Gold Dealers in a terrible position. Obviously, XYZ has the option to claim they are unable to pay the  amount and renege on the agreement. Obviously, what comes next will be a protracted and difficult judicial battle, but that is not the area of our concern.The important thing to remember is that a forward agreement has a very large scope and incentive to default.

Given that the futures market is an evolution of the forwards market, the default perspective is handled carefully and strategically. The margins come into play in this situation.

There is no regulation in the forwards market. There is essentially no third party overseeing the transaction between the two parties when they come to an agreement. In contrast, all trades in the futures market go through an exchange. In exchange, the exchange assumes responsibility for ensuring the settlement of all trades. When I say “onus of guaranteeing,” I mean that the exchange is responsible for ensuring that you receive your money if you are eligible. This also means that they make sure to collect the funds from the responsible party.

How does the exchange ensure that everything runs well then? They accomplish this by using –

1, Taking notes on the margins

2, putting a market price on daily gains or losses (also called M2M)

In the preceding chapter, we only skimmed the topic of margin. To completely understand the dynamics of futures trading, it is necessary to have a parallel understanding of the concepts of margin and M2M. I would like to pause briefly on margins and go on to M2M, though, because it is challenging to describe both concepts at once. We’ll fully comprehend M2M before returning to margins. Then, while keeping M2M in mind, we will revisit margins. However, before we go on to M2M, I want you to keep the following things in mind:

  1. Margin in your trading account is when you start a futures position.
  2. The “Initial Margin” is another name for the margins that are.
  3. The SPAN margin and the Exposure Margin are the two parts that make up the initial margin.
  4. SPAN Margin + Exposure Margin = Initial Margin
  5. Your trading account’s initial margin will be frozen for the number of days you decide to keep the futures trade open.

1. The initial margin’s value changes every day because it is  on the futures price.

2. Keep in mind that the initial margin equals a percentage of the contract value.

3. Futures price times lot size equals contract value.

4. Although the lot size is set, the futures price changes daily. This implies that the margins change daily as well.

So, for now, focus on these few ideas. We’ll move on to understanding M2M before returning to the margins to finish this chapter.

5.3 – Mark to Market (M2M)

As we all are aware, the futures price changes every day, and depending on the circumstances, you could earn or lose money. Marking to market, often known as M2M, is a straightforward accounting process that entails modifying your daily profit or loss and granting you the same. M2M is effective while the futures contract is still in your possession. Let’s use a clear example to illustrate this.

Let’s say you decide to purchase Hindalco Futures on December 1st, 2014, at a price of Rs. 165. The Lot is 2000 square feet. You choose to square off the position at 2:15 PM on December 4, 2014, for Rs. 170.10/-, 4 days later. The formula below clearly demonstrates that this is a profitable trade.

Buy Price = Rs.165

Sell Price = Rs.170.1

Profit per share = (170.1 – 165) = Rs.5.1/-

Total Profit = 2000 * 5.1

= Rs.10,200/-

But the transaction was  for four working days. The profit or loss on the futures contract is  to market every day it is held. The prior day’s closing price is  as a benchmark when marking to market in order to determine gains or losses.

The price movement of futures over the four days the contract was in force is  in the table above. Let’s examine daily events to better grasp how M2M functions.

The futures contract was  on Day 1 at 11:30 AM for Rs.165. It is obvious that the price increased after the contract was  because it closed that day at Rs.168.3. Thus, the daily profit is 168.3 minus 165, or Rs. 3.3 per share. The lot size is 2000, hence the daily net profit is equal to 3.3 * 2000, or Rs. 6600.

Therefore, the exchange makes sure that Rs. 6,600 is  to your trading account at the end of the day (via the broker).

  1. But from where does this money come?

1. It is without a doubt originating from the counterparty. It follows that the exchange is also making sure the counterparty pays Rs. 6,600 toward his loss.

2. But how does the transaction make sure they receive payment from the obligated party?

  1. Obviously, through the margin deposits made at the moment the deal is. But more on that in a moment.

Another crucial point that you should be aware of is that the futures buy price will no longer be treated as Rs. 165 but rather as Rs. 168.3/- from an accounting standpoint (closing price of the day). You may wonder why that is the case. You have already received the day’s profit by crediting your trading account. As a result, you are  to be in the right for the day, and tomorrow is  as a new day. As a result, the buy price is now set at Rs. 168.3, the day’s closing price.

The futures finished at Rs. 172.4/- on day 2, indicating another profitable day. The net profit for the day would be Rs. 8,200, or Rs. 4.1 per share, less the day’s profit of Rs. 172.4. Your trading account will be  with the earnings you are  to, and the buy price will be changed to the previous day’s closing price of 172.4/-.

Day 3‘s closing price of Rs. 171.6 indicates that there was a loss of Rs. 1600 compared to day 2’s close price (172.4 – 171.6 * 2000). Your trading account will be automatically debited for the lost amount. Additionally, the buy price has been changed to Rs. 171.6.

On day 4, the trader chose to close the position at 2:15 PM, or midday, at a price of Rs. 170.10 instead of holding it throughout the day. As a result, he suffered a loss for the day’s close. This would result in a loss of Rs. 171.6/- less Rs. 170.1/-, or Rs. 1.5/- per share, and a net loss of Rs. 3000/- (1.5 * 2000). Naturally, since the trader has squared off his position, it makes no difference where the futures price goes after the square off. By the conclusion of the day, Rs. 3000 is also debited from the trading account.

The amount we initially calculated, which is -, will remain the same if you add up all the M2M cash flow.

Purchase Price: Rs. 165

Sell Price = 170.1 rupees

Profit per share is (170.1 – 165), which equals Rs.5.1.

Profit total = 2000 * 5.1

= Rs.10,200/-

Therefore, a daily accounting adjustment where –

  1. Depending on how the futures price responds, money is either or debited (also as the daily obligation).
  2. The current M2M is by taking into account the previous day’s close price.

Why, in your opinion, is M2M necessary in the first place? Consider the fact that M2M is a daily cash adjustment through which the exchange significantly lowers the risk of counterparty default. The exchange by the M2M ensures both parties are daily fair and square as long as a trader keeps the contract.

Let’s go back and revisit margins while keeping in mind the fundamentals of M2M to see how the deal changes over the course of its existence.

5.4 – Margins, the bigger perspective

Let’s take another look at margins while keeping M2M in mind. The margins needed to start a futures trade are known as “Initial Margin (IM),” as was previously noted. A specific percentage of the contract value is the first margin. Additionally, we are aware of

Initial Margin (IM) = SPAN Margin + Exposure Margin

 

 

Few financial intermediaries operate behind the scenes each time a trader initiates a futures deal (or any trade, for that matter). They make sure the trade goes through without a hitch. The broker and the exchange are the two important financial intermediaries.

Of course, the broker and the exchange will suffer financially if the client breaches a contract. Therefore, proper coverage utilising a margin deposit is required if both financial intermediaries are to be  against a potential customer default.

In actuality, this is exactly how it operates: “SPAN Margin” refers to the minimum required margins  in accordance with the mandate of the exchange, and “Exposure Margin” refers to the margin  above and above the SPAN to protect against potential MTM losses. Keep in mind that the exchange specifies SPAN and Exposure margin. Therefore, the client must abide by the first margin requirement while starting a futures trade. The full initial margin (SPAN + Exposure) is  by the exchange.

Between the two margins, SPAN Margin is more crucial because failure to have it in your account would result in a penalty from the exchange. To carry a position overnight or the following day, the trader must adhere strictly to the SPAN margin requirement. The “Maintenance Margin” is another name for SPAN margin that is sometimes used.

How does the exchange determine what the SPAN margin requirement for a specific futures contract should be ? The SPAN margins are  each day using an advanced algorithm. The ‘Volatility’ of the stock is one of the important inputs that this algorithm takes into account. Volatility is a highly important subject, and we shall go into great detail about it in the following module. Just keep in mind this for the moment: if volatility is anticipated to increase, the SPAN margin required increases as well.

The additional margin known as exposure margin ranges from 4% to 5% of the contract value.

You may already be aware if you trade with Zerodha that the SPAN and exposure margin requirements are  clearly in our margin calculator. Of course, we’ll go into more depth about the usefulness of this handy tool later on. However, you may look at this margin estimator for the time being.

Keeping the aforementioned transaction specifics in mind, let’s examine how margins and M2M interact concurrently during the course of the trade. The table below illustrates how the dynamics alter daily.

I hope the table above doesn’t overwhelm you; in reality, it is pretty simple to understand. Let’s go through everything day by day in order.

10th Dec 2014

The HDFC Bank futures contract was  for Rs. 938.7 at some point in the day. There are 250 square feet on the land. The contract’s value is therefore Rs. 234,675/-.

As we can see from the box on the right, SPAN makes up 7.5 percent of CV while Exposure makes up 5 percent. As a result, 12.5 percent of the CV is set aside for margins (SPAN + Exposure), which comes to a total margin of Rs. 29,334/-. The first margin is sometimes regarded as the initial sum of money the broker has .

HDFC will now close for the day at 940. The CV has increased to Rs. 235,000 at 940, making the total margin needed Rs. 29,375, a slight increase of Rs. 41 above the margin needed at the time the transaction was ]. The client is not  to add this money to his account because he would have an M2M profit of Rs. 325 that will cover his needs.

Cash Balance + M2M equals the total amount of cash in the trading account.

= Rs.29,334 + Rs.325

= Rs.29,659/-

There is no issue because the cash amount clearly exceeds the whole margin requirement of Rs. 29,375. Additionally, the reference rate for the M2M for the following day is now set at Rs. 940.

11th Dec 2014

The M2M was negatively affected by Rs. 250 the day after HDFC Bank’s share price dropped by Rs. 1 to Rs. 939. This sum is  from the available cash (and will be  to the person making this money). The new cash balance will therefore be –

= 29659 – 250

= Rs.29,409/-

Additionally, a new margin need of Rs. 29,344 is . There is no need to worry because the cash balance is bigger than the necessary margin.

Additionally, the reference rate for the M2M for the following day is reset to Rs.939.

12th Dec 2014

It’s a fascinating day today. The futures price decreased by Rs. 9 to become Rs. 930 per share. The margin needed also decreases at Rs.930/- to Rs.29,063/-. The cash balance falls to Rs. 27,159/- (29409 – 2250), which is less than the whole margin need, due to an M2M loss of Rs. 2,250. Is the client compelled to put up the extra cash because the cash balance is less than the overall margin requirement? Actually, no.

Keep in mind that the SPAN margin is the more revered of the two margins, followed by the Exposure margin. As long as you have the SPAN Margin, most brokers will let you keep your holdings (or maintenance margin). When the cash balance is lower than the maintenance margin,You will receive a call from them requesting additional funding. If not, they will compel the positions to shut on their own. This call from the broker asking you to deposit the necessary margin funds is also known as the “Margin Call.” Your cash balance is too low to maintain the trade if your broker is sending you a margin call.

Returning to the example, there is no issue because the cash balance of Rs. 27,159 is greater than the SPAN margin of Rs. 17,438. The M2M loss is deducted from the trading account, and the reference rate is then reset to Rs. 930 for the M2M transaction the next day.

Well, I hope you now have a better understanding of how margins and M2M interact. I also hope you can see how effectively the exchange can deal with a potential default threat thanks to the margins and M2M. The margin plus M2M combination is essentially a surefire way to prevent defaults.

I’ll take the liberty of skipping the next days and going straight to the last trading day in the event that you’re beginning to understand how margins and M2M calculations work.

19th Dec 2014

The trader makes the decision to cash out and settle the contract at 955. The closing rate from the day before, which is Rs. 938, serves as the M2M reference rate. Therefore, the M2M profit would be Rs. 4250, which is added to the cash amount of Rs. 29,159 from the previous day. When the trader squares off the trade, the broker will release the remaining cash amount of Rs. 33,409 (Rs. 29,159 + Rs.

What about the trade’s overall P&L? Well, there are numerous methods for calculating this:

Method 1: Add up all M2Ms.

P&L = the total of all M2Ms

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

= Rs.4,075/-

Second Approach: Cash Release

P&L = Total Cash Flow (released by broker) – Cash Was Initially  (initial margin)

= 33409 – 29334

= Rs.4,075/-

Procedure 3: Contract Value

P&L is equal to Final Contract Value less Initial Contract Value.

= Rs.238,750 – Rs.234,675

=Rs.4,075/-

Fourth Approach: Futures Price

P&L is (difference between the futures buy price and sale price) * Lot Size.

Buy at $938.7, sell at 955, and have a 250-piece lot.

= 16.3 * 250

= Rs. 4,075/-

As you can see, using either method of calculation results in the same P&L value.

5.5 – An interesting case of ‘Margin Call.’

Let’s pretend for a second that the trade was not closed on December 19 and was instead carried over to December 20. Let’s further say that HDFC Bank experiences a significant decline on December 20 — perhaps an 8 percent decline that causes the price to drop from 955 to 880. What do you anticipate happening? Can you actually respond to these inquiries?

 

  1. What is the P&L for M2M?
  2. How does it affect the cash balance?
  3. What SPAN and exposure margin is necessary?
  4. How does the broker proceed?

 

I hope you can figure these out on your own, but if not, I’ll give you the answers:

The M2M loss is calculated as (955 – 880)*250 or Rs. 18,750. The cash balance as of December 19 was Rs. 33,409; the M2M loss would be subtracted from this amount to leave a cash balance of Rs. 14,659 (Rs. 33,409 – Rs. 18,750).

  1. Because the cost has decreased, the new contract value is Rs. 220,000 (250 x 880).
  2. SPAN equals 7.5 percent times 220000, or Rs. 16,500.

1. Exposure equals $11,000.

2. Total Margin = 27,500 rupees

 

3. The broker will obviously issue a margin call to the client because the cash balance (Rs. 14,659) is less than the SPAN Margin (Rs. 16,500), and some brokers will actually close the transaction as soon as the cash balance falls below the SPAN requirement.

 

CONCLUSION

  1. As long as the futures trade is active, a margin payment is necessary (which your broker will prohibit).
  2. The initial margin refers to the margin that the broker stopped when the futures trade was first initiated.
  3. The initial margin deposit will be required from both the buyer and the seller of the futures contract.
  4. The amount of margin obtained serves as leverage by enabling you to deposit a modest sum of money and participate in a transaction with a high value.
  5. The M2M method, which entails crediting or debiting the daily obligation funds in your trading account depending on how the futures price behaves, is a straightforward accounting adjustment.
  6. The closing price from the day before is used to determine the M2M for the current day.

  7. Exposure Margin is collected in accordance with the broker’s requirements, while SPAN Margin is collected in accordance with the exchange’s instructions.

  8. The SPAN and Exposure Margin are calculated in accordance with exchange standards.

  9. The Maintenance Margin is the common name for the SPAN Margin.

  10. If the investor wants to continue forward the future position, he must deposit more money into his account if the margin account falls below the SPAN.

  11. When the cash balance falls below the necessary level, the broker will issue a “margin call” and ask the trader to inject the necessary margin money.