Margins, the bigger perspective
Let us review margins from a M2M perspective once more. As stated before, the necessary amount of funds for a futures trade is referred to as “Initial Margin (IM)”. This amount is usually a certain percentage of the contract’s total value. It is also worth noting –
Initial Margin (IM) = SPAN Margin + Exposure Margin
Every time a futures trade is initiated, many financial intermediaries work behind the scenes to ensure it runs smoothly. The two major players in this process are the broker and the exchange.
In the event of a client defaulting on an obligation, it will obviously have financial implications for the broker and the exchange. Thus, to protect both the financial intermediaries against potential defaults, they must be sufficiently covered with margin deposits.
This is how it goes: The exchange has requirements for what margins must be blocked as ‘SPAN Margin’ and also ‘Exposure Margin’. This combined initial margin (SPAN + Exposure) must be considered when initiating a futures trade, as they are specified by the exchange which blocks the whole amount.
SPAN Margin has a special significance since failing to meet the requirement may incur a penalty from the exchange. Maintaining this margin is essential if the trader intends to keep their position open overnight/next day; thus, SPAN Margin is also known as the “Maintenance Margin”.
The exchange decides the SPAN margin requirement for a futures contract using an intricate algorithm. One factor that goes into the equation is ‘Volatility’ of the stock, which we will go into in much more detail in the upcoming module. For now, keep in mind that when volatility is anticipated to increase, so does the SPAN margin requirement.
The additional margin required, known as exposure margin, varies between 4-5% of the contract’s value.
Let us consider now a futures transaction, with both the margin and the M2M viewpoint.
We offer a Margin calculator that states SPAN and Exposure margin requirements. We’ll discuss the tool in greater depth later on, but for now, you can give it a try.
Let us now analyse how the margins and M2M influence the trade’s lifespan. The table below illustrates the day-to-day shifts in dynamics –
Don’t be daunted by what you see in the table; it’s actually quite simple. Let us look through it step-by-step, day after day.
10th Dec 2014
At some point during the day, a HDFC Bank futures contract was procured at Rs.938.7/- and its lot size is 250. This results in a contract value of Rs.234,675/-. Inspecting the information present on the right-hand side, we can understand that SPAN is charged at 7.5%, while Exposure is 5% of CV; combined, the margins blocked amount to 12.5% of CV, which corresponds to Rs.29,334/- as total margin amount. Additionally, it is also considered as initial cash held by the broker for this transaction.
HDFC closes at 940 for the day, making the CV Rs.235,000/-. The total margin requirement slightly rises by Rs.41/- from the initial amount, but there’s no need to deposit more funds – the client has an M2M profit of Rs.325/- in his account, which will be credited.
The total cash balance in the trading account = Cash Balance + M2M
= Rs.29,334 + Rs.325
The cash balance is significantly larger than the total margin requirement of Rs.29,375/-, thus there should be no issue. Additionally, the reference rate for tomorrow’s M2M has been fixed at Rs.940/-
11th Dec 2014
The following day, HDFC Bank’s stock decreased by one rupee to a rate of nine hundred and thirty-nine per share, resulting in a M2M decrease of two hundred and fifty rupees. This amount will be taken out of the cash balance and transferred to whoever earned it. The new cash balance will thus be…
= 29659 – 250
The cash balance is substantially higher than the margin requirement of Rs.29,344/-, so there is no cause for concern. The reference rate for the following day’s M2M has been reset at Rs.939/-.
12th Dec 2014
Today is an interesting day, with futures prices dropping to Rs.930/- per share, taking the margin requirement to Rs.29,063/-. However, after a M2M loss of Rs.2250/- the cash balance drops to Rs.27,159/-; this amount is lesser than the total margin requirement. Will the client be required to put in additional funds? The answer is no.
Recall that the SPAN margin is the most important one to maintain. Most brokers will let you retain your positions provided your SPAN margin level is sufficient. However, if it falls below the maintenance margin, they will reach out to ask for additional funds. If these are not supplied in a timely fashion, they may be forced to close your positions. This request from the broker for more money is called a “Margin Call”; if you receive one, it means your cash balance is too low to keep holding the position.
Turning again to the instance, since the cash balance of Rs.27,159/- exceeds the SPAN margin (Rs.17,438/-), there is no difficulty. The M2M deficit is charged to the trading account and for the subsequent day’s M2M, the reference rate is set at Rs.930/-.
I hope you now understand how margins and M2M can both be employed to avoid default threats. This combination creates almost complete assurance that defaults will not take place.
With a good awareness of margins and M2M computation, I shall now take the privilege to jump ahead to the last trading day.
19th Dec 2014
At 955, the trader opts to close their trade. The reference rate for M2M is that day’s previous closing rate of Rs.938so they earn a profit of Rs.4250/- which adds on to the pre-existing cash balance of Rs.29,159/-. This brings the overall cash balance to Rs.33,409/- and then will be released in full by the broker once they have squared off their trade.
So, what about the overall P&L of the trade? Well, there are many ways to calculate this –
Method 1) – Sum up all the M2M’s
P&L = Sum of all M2M’s
= 325 – 250 – 2250 + 4750 – 4000 – 2000 + 3250 + 4250
Method 2) – Cash Release
P&L = Final Cash balance (released by broker) – Cash Blocked Initially (initial margin)
= 33409 – 29334
Method 3) – Contract Value
P&L = Final Contract Value – Initial Contract Value
= Rs.238,750 – Rs.234,675
Method 4) – Futures Price
P&L = (Difference b/w the futures buy & sell price ) * Lot Size
Buy Price = 938.7, Sell Price = 955, Lot size = 250
= 16.3 * 250
= Rs. 4,075/-
As you can notice, either of which ways you calculate, you arrive at the same P&L value.
– An interesting case of ‘Margin Call.’
Let us conjecture that the trade had not been concluded on 19th December, and instead, continued to the next day. Additionally, let us speculate that HDFC Bank fell significantly on 20th December – say 8%, causing the cost to plunge from 955 to 880. What do you think would happen then? Are you able to respond to the ensuing questions?
I hope you can calculate and answer these questions yourself; if not, here are the answers for you –