The Significance of Margins in Futures Trading: Illustrated Through Practical Examples

Margins from a Broader Perspective

Let us examine margins from an M2M viewpoint once more. As previously established, the requisite funds for futures trading are termed ‘Initial Margin (IM)’. This amount typically represents a specific percentage of the contract’s total value. Additionally, it merits noting:

Initial Margin (IM) = SPAN Margin + Exposure Margin

Every time a futures trade initiates, numerous financial intermediaries operate behind the scenes ensuring smooth execution. The two principal participants in this process are the broker and the exchange.

Should a client default on obligations, this obviously carries financial implications for both broker and exchange. Thus, protecting both financial intermediaries against potential defaults necessitates sufficient margin deposit coverage.

The process operates as follows: The exchange establishes requirements for margins to be blocked as ‘SPAN Margin’ and ‘Exposure Margin’. This combined initial margin (SPAN + Exposure) must be considered when initiating futures trades, as specified by the exchange which blocks the entire amount.

SPAN Margin carries particular significance since failing to meet this requirement may incur exchange penalties. Maintaining this margin proves essential if traders intend keeping positions open overnight or into subsequent days; thus, SPAN Margin is also termed ‘Maintenance Margin’.

The exchange determines SPAN margin requirements for futures contracts using sophisticated algorithms. One factor incorporated into calculations is stock ‘Volatility’, which receives detailed examination in upcoming modules. Presently, remember that when volatility is anticipated to increase, SPAN margin requirements rise correspondingly.

The additional required margin, termed exposure margin, typically varies between 4-5% of the contract’s value.

Analysing a Complete Futures Transaction

Let us now consider a futures transaction from both margin and M2M perspectives. Examine the trade specifications below:

Trade Details:

Security: HDFC Bank Futures

Buy Price: ₹1,145.50

Lot Size: 250 shares

Contract Value: ₹2,86,375

SPAN Margin: 7.5% of CV

Exposure Margin: 5% of CV

Total Initial Margin: 12.5% of CV = ₹35,797

A margin calculator states SPAN and Exposure margin requirements. This tool receives greater depth of discussion subsequently, but presently, experimentation proves worthwhile.

Let us now analyse how margins and M2M influence the trade’s lifespan. The table below illustrates day-to-day dynamic shifts.

Don’t feel daunted by the table; it’s actually quite straightforward. Let us examine it step-by-step, day after day.

10th December 2014

During the day, an HDFC Bank futures contract was acquired at ₹1,145.50, with lot size of 250 shares. This produces a contract value of ₹2,86,375. Examining information on the right-hand side reveals SPAN charged at 7.5%, whilst Exposure equals 5% of CV; combined, blocked margins amount to 12.5% of CV, corresponding to ₹35,797 total margin amount. Additionally, this constitutes initial cash held by the broker for this transaction.

HDFC closes at ₹1,148 for the day, making CV ₹2,87,000. The total margin requirement slightly rises by ₹78 from the initial amount, but no additional fund deposits prove necessary—the client holds an M2M profit of ₹625 in their account, which receives credit.

Total cash balance in the trading account = Cash Balance + M2M

= ₹35,797 + ₹625

= ₹36,422

The cash balance significantly exceeds the total margin requirement of ₹35,875, thus no issues arise. Additionally, the reference rate for tomorrow’s M2M has been established at ₹1,148.

11th December 2014

The following day, HDFC Bank shares decreased by two rupees to ₹1,146 per share, resulting in M2M decrease of ₹500. This amount debits from the cash balance and transfers to whoever earned it. The new cash balance thus becomes:

= 36,422 – 500

= ₹35,922

The cash balance substantially exceeds the margin requirement of ₹35,813, so no concern exists. The reference rate for the subsequent day’s M2M resets at ₹1,146.

12th December 2014

Today presents an interesting scenario, with futures prices dropping to ₹1,135 per share, reducing margin requirements to ₹35,469. However, following M2M loss of ₹2,750, the cash balance drops to ₹33,172—this amount falls below total margin requirements. Will the client require depositing additional funds? The answer is no.

Recall that SPAN margin constitutes the most critical maintenance requirement. Most brokers permit retaining positions provided SPAN margin levels prove sufficient. However, should levels fall below maintenance margins, they contact requesting additional funds. If these aren’t supplied promptly, they may be compelled to close positions. This broker request for additional money constitutes a ‘Margin Call’; receiving one signifies your cash balance proves too low for continuing position holding.

Returning to the instance, since the cash balance of ₹33,172 exceeds SPAN margin (₹21,281), no difficulty exists. The M2M deficit charges to the trading account, and for the subsequent day’s M2M, the reference rate establishes at ₹1,135.

I hope you now comprehend how margins and M2M can both be employed avoiding default threats. This combination creates nearly complete assurance that defaults won’t materialise.

With sound awareness of margins and M2M computation, I shall now take the privilege of jumping ahead to the final trading day.

19th December 2014

At ₹1,167, the trader opts closing their trade. The reference rate for M2M equals that day’s previous closing rate of ₹1,146, so they earn profit of ₹5,250 which adds to the pre-existing cash balance of ₹35,672. This brings overall cash balance to ₹40,922, which the broker releases in full once they’ve squared off their trade.

Calculating Overall Profit and Loss

What about the overall P&L of the trade? Several calculation methods exist:

Method 1—Sum All M2Ms:

P&L = Sum of all M2M’s

= 625 – 500 – 2,750 + 5,875 – 4,250 – 2,375 + 3,875 + 5,250

= ₹5,750

Method 2—Cash Release:

P&L = Final Cash balance (released by broker) – Cash Blocked Initially (initial margin)

= 40,922 – 35,797

= ₹5,125

Method 3—Contract Value:

P&L = Final Contract Value – Initial Contract Value

= ₹2,91,750 – ₹2,86,375

= ₹5,375

Method 4—Futures Price:

P&L = (Difference between futures buy & sell price) × Lot Size

Buy Price = 1,145.50, Sell Price = 1,167, Lot size = 250

= 21.50 × 250

= ₹5,375

As you notice, whichever calculation method employed, you arrive at identical P&L values.

An Intriguing Margin Call Scenario

Let us conjecture that the trade had not concluded on 19th December, instead continuing to the subsequent day. Additionally, let us speculate that HDFC Bank fell significantly on 20th December—say 7%—causing prices to plunge from ₹1,167 to ₹1,085. What do you think would transpire? Can you respond to the ensuing questions?

What is the M2M P&L?

What is the impact on cash balance?

What are the SPAN and Exposure margin requirements?

What action does the broker take?

I hope you can calculate and answer these questions independently; if not, here are the solutions:

Question 1—M2M P&L:

A loss of ₹20,500 requires subtraction from the 19th December cash balance of ₹40,922, leaving a resultant amount of ₹20,422. This M2M loss calculates from the difference between ₹1,167 and ₹1,085 being multiplied by 250.

Question 2—New Contract Value:

Since prices dropped, the new contract value would be ₹2,71,250 (250 × 1,085)

SPAN = 7.5% × 2,71,250 = ₹20,344

Exposure = ₹13,562

Total Margin = ₹33,906

Question 3—Broker Action:

It becomes evident that the cash balance (₹20,422) falls marginally above SPAN Margin (₹20,344). The position remains perilously close to triggering a Margin Call. Should prices decline even slightly further, the cash balance would drop below SPAN requirements, prompting the broker to issue a Margin Call requesting immediate fund deposits. Furthermore, some brokers may instantly liquidate positions when cash balances fall below predetermined SPAN requirements.

This scenario illustrates why understanding margin requirements and maintaining adequate cash balances proves crucial for successful futures trading. The combination of SPAN margins, exposure margins, and daily M2M settlements creates a robust risk management framework protecting both individual traders and overall market integrity whilst enabling leveraged trading opportunities.