It’s essential to comprehend the concept of margins in futures trading, since this provides an opportunity for leveraging. Without margins, the Futures Agreement would simply not be economically feasible when compared to spot market transactions. Therefore, it is critical that you gain insight into all aspects of margin.
Before continuing, let us summarise the key concepts that we’ve learnt over the last 4 chapters. It’ll aid in consolidating all the knowledge. If any of these ideas are hazy to you, then it may be necessary to recap the prior chapters and familiarise yourself with them.
- The futures contract is based on the same type of setup as its forward market counterpart.
- A futures contract allows you to gain financially if you have an accurate assumption of the asset’s value.
- The worth of a futures contract is derived from the value of its related spot market asset.
- The futures agreement derives its value from its corresponding underlying in the spot market.
- For example, TCS Futures derives its value from the underlying in the TCS Spot market.
- The Futures price mimics the underlying price in the spot market.
- The futures price and the spot price of an asset differ, which is due to the futures pricing formula. We will discuss this point further in the module.
- The futures contract is a standardised contract wherein the agreement variables are predetermined – lot size and expiry date.
- The lot size is the minimum quantity specified in the futures contract.
- Contract value = Futures Price * Lot Size
- Expiry is the last date up to which one can hold the futures agreement.
- To enter into a futures agreement, one has to deposit a margin amount calculated as a certain % of the contract value.
- Margins allow us to deposit a small amount of money and take exposure to a large value transaction, thereby leveraging the transaction.
- When we transact in a futures contract, we digitally sign the agreement with the counterparty; this obligates us to honour the contract upon expiry.
- The futures agreement is tradable, so you don’t have to keep it until the due date.
- You can hang onto the futures contract so long as you believe in the asset’s directional movement; when your perspective shifts, you can disengage from the futures agreement.
- You can hold the futures agreement for a short period and profit if the market moves in your direction.
- An example of this would be to purchase Infosys Futures at 9:15 AM for 1951 and sell it by 9:17 AM for 1953. The lot size of Infosys is 250, which means the potential profit from the transaction within the space of two minutes is Rs.500/-.
- You can even choose to hold it overnight for a few days or hold on to it till expiry.
- Equity futures contracts are cash-settled
- Under leverage, a small change in the underlying results in a massive impact on the P&L
- The profits made by the buyer is equivalent to the loss made by the seller and vice versa.
- Futures Instrument allows one to transfer money from one pocket to another. Hence it is called a “Zero Sum Game.”
- The higher the leverage, the higher the risk.
- The payoff structure of a futures instrument is linear.
- The Securities and Exchange Board of India (SEBI) monitors the futures market, ensuring that there is no default by parties on either side.
Once you have a firm grasp of the ideas laid out in this guide, you should be on your way to success. If any of the concepts are unclear, take time to go through the prior four chapters again.
Assuming that you understand, we can now focus on margins and mark to market concepts.
– Why are Margins charged?
Let us go back to the example discussed in chapter 1, which involves ABC Jewellers agreeing to purchase 15Kg of gold at Rs.2450/- per gram from XYZ Gold Dealers in three months’ time.
It’s evident that the price of gold has a noticeable impact on ABC and XYZ Gold Dealers. Should the price rise, XYZ will incur losses and ABC will have a profit to its name. However, if things move in the other direction, ABC suffers, while XYZ takes advantage. Of course, when it comes to forwards agreements, they are based off of trust and honouring promises made. But what happens if prices increase drastically? Should this occur, then XYZ can opt not to fulfil the payment requirements and instead default on the agreement – an act which usually results in a long legal challenge. Ultimately, forwards agreements provide a high incentive to breach their obligations without repercussions.
The futures market builds upon the forwards market, and margin factors must be taken into consideration when dealing with default risks.
In the forwards market, there is no intermediary overseeing the transaction. The two parties involved simply enter into an agreement. Conversely, all trades in the futures market are done through an exchange. It safeguards each side’s financial interests by guaranteeing both payment and collection of money due. In other words, you’ll get your money if it’s yours, and they’ll collect the money from whoever owes it.
The exchange guarantees smooth functioning by utilising various methods.
- Collecting the margins
- Marking the daily profits or losses to market (also called M2M)
In the previous chapter, we gave a brief overview of Margin. To fully understand the implications of futures trading, it is important to grasp both Margin and M2M. The two topics are often hard to explain together, so for now we will focus on M2M and come back to Margin later. Before doing that, keep these points in mind…
- At the time of initiating the futures position, margins are blocked in your trading account.
- The margins that get blocked is also called the “Initial Margin.”
- The initial margin is made up of two components, i.e. SPAN margin and the Exposure Margin.
- Initial Margin = SPAN Margin + Exposure Margin
- Initial Margin will be blocked in your trading account for how many days you choose to hold the futures trade.
- The value of the initial margin varies daily as it depends on the futures price.
- Remember, Initial Margin = % of Contract Value
- Contract Value = Futures Price * Lot Size
- The lot size is fixed, but the futures price varies every day. This means the margins also vary every day.
Therefore, for the time being, keep these few points in mind. We shall move on to explore M2M, and then return to margins in order to finish this chapter.