Comprehending Mark to Market (M2M) in Futures Trading

Daily price fluctuations in futures generate either profits or losses. Mark to market (M2M) functions to adjust gains or losses accordingly, crediting or debiting your account whilst the contract remains held. To illustrate, examining a straightforward example proves instructive.

Practical M2M Application

Assume on 1st December 2014 around 11:30 AM, you decide purchasing Hindalco futures at ₹165. The lot size equals 2,000 shares. Four days later, on 4th December 2014, you decide squaring off the position at 2:15 PM at ₹170.10. Clearly, as calculations below demonstrate, this constitutes a profitable trade:

Trade Parameters:

Buy Price = ₹165

Sell Price = ₹170.10

Profit per share = (170.10 – 165) = ₹5.10

Total Profit = 2,000 × 5.10 = ₹10,200

The trade spanned four working days, with each day’s profits or losses being marked-to-market against the previous day’s closing price.

Daily M2M Analysis

Examining the table detailing futures price movements over the four-day duration enables analysing M2M performance. Observing daily changes provides insight into process operations.

Day One Performance

The futures contract was purchased at ₹165 on Day 1 at 11:30 AM and closed at ₹168.30, resulting in ₹3.30 profit per share. Since lot size equalled 2,000, total gain reached ₹6,600.

This signifies that, through the broker’s services, your trading account receives ₹6,600 credit at day’s end.

Critical Questions Arise:

Funding Source: Where does this ₹6,600 originate?

Evidently, the counterparty must compensate their ₹6,600 loss, with the exchange guaranteeing payment.

Payment Guarantee Mechanism: How does the exchange ensure receiving money from the obligated individual?

Upon initiating trades, deposited margins become relevant. Further coverage follows subsequently.

Importantly, from an accounting perspective, the futures buy price no longer registers as ₹165 but rather ₹168.30 (the day’s closing price). Reasoning: since daily profit has already been credited to your trading account, a fresh beginning occurs regarding profits and losses. Therefore, the buy price resets to that day’s closing rate of ₹168.30.

Day Two Performance

On day 2, futures closed at ₹172.40, generating ₹4.10 profit per share or ₹8,200 net total. Following this credit to the trading account, the buy price resets to that day’s closing rate of ₹172.40.

Day Three Performance

On day 3, futures closed at ₹171.60, representing a ₹0.80 per share decrease from yesterday’s closing price (172.40 – 171.60), totalling ₹1,600 loss (0.80 × 2,000). This amount automatically debits from your trading account, with buy price now reset to ₹171.60.

Day Four Performance

On day 4, despite holding the position until 2:15 PM, the trader decided squaring off at ₹170.10. Consequently, a net loss of ₹1.50 per share materialised, totalling ₹3,000 (1.50 × 2,000). Following position closure, subsequent price movements became irrelevant, with the account reflecting ₹3,000 total debit by day’s end.

Cumulative M2M Cash Flow

Calculating daily mark-to-market worth and examining earned and spent amounts proves illuminating:

Daily M2M Summary:

Day 1: +₹6,600 (Credit)

Day 2: +₹8,200 (Credit)

Day 3: -₹1,600 (Debit)

Day 4: -₹3,000 (Debit)

Net Total: +₹10,200

Aggregating all M2M cash flows yields the identical sum initially calculated:

Buy Price = ₹165

Sell Price = ₹170.10

Profit per share = (170.10 – 165) = ₹5.10

Total Profit = 2,000 × 5.10 = ₹10,200

M2M Fundamental Principles

Mark to market constitutes a daily accounting adjustment wherein:

Cash deposited or withdrawn depends upon futures market movements. This represents daily obligation settlement.

Yesterday’s closing price determines today’s M2M calculation.

M2M Purpose and Benefits

What purpose does M2M serve? It functions as daily cash adjustment, significantly reducing counterparty default risk. Throughout the trader’s contract possession, this process ensures both sides receive fair and equitable outcomes daily.

The M2M mechanism prevents accumulation of large outstanding obligations that might incentivise default. By settling gains and losses daily, the exchange ensures that profitable parties receive their entitlements immediately, whilst loss-making parties discharge obligations incrementally rather than facing overwhelming settlement amounts at contract expiry.

This daily settlement structure distinguishes futures markets from forwards markets, where settlement occurs only at contract conclusion, creating substantial default risk when accumulated obligations become significant.

Returning to Margin Considerations

Having comprehended M2M mechanics, returning to margins enables observing trade development throughout its lifespan. The interplay between margins and M2M creates the robust risk management framework that underpins futures market integrity and participant confidence in contract enforceability.

Understanding how initial margins provide security deposits, whilst M2M ensures daily settlement, illuminates why futures markets successfully facilitate substantial transaction volumes whilst maintaining remarkably low default rates compared to unregulated forwards market structures. This combination of margin requirements and daily settlement constitutes the foundation enabling leveraged trading with acceptable risk parameters for both individual participants and overall market stability.