Margins play an extremely crucial role in futures trading, making the concept of future trading extremely profitable in nature. Hence we present to you a brief understanding of margins, how they are charged, and what role do they play in future trading. We firmly believe that theoretical knowledge is not enough to understand margins, so throughout the blog, we will discussed with the help of a practical situation associated with margins.
Suppose a person ABC want to engage in futures trading. After doing all the technical analysis, he comes up with a view that Reliance Industries is headed for a technical breakout and a considerable upswing. ABC wants to take advantage of the boom but is faced with a dilemma of either taking a cash or a futures position. He sees that the possibility of higher returns lies in the futures market. But he is unable to understand the concept of margins and how they are charged. Therefore he calls up his Relationship Manager at Hensex Securities about how margins are calculated and what other things he should keep in mind. The relationship manager listen to Mr. ABC’s queries patiently and start explaining about margins:
To explain easily, margins are like a token value collected for the entire position. Just like when you are looking to buy a property and pay the token to book your reservation, margins are a token for the entire futures position. And just like the token for the property is charged concerning variations and volatility in the market, margins are collected in a similar way and a much more transparent manner. The margin collected is based on a simple concept of VaR.
Let’s take an example of an XYZ stock. Since the margin is only collected as a certain percentage of the value of the contract, the stock exchange wants to ensure that the margin should be enough to account for the price movements of the stock. To do this, the exchange collects data about the price movements of the particular stock and calculates the variations that occur in them. Those variations are then plotted on graphs to identify significant price movements that can occur. Based on this data, the exchange can determine the maximum deviation that can happen in the price. Usually, the exchange uses a 95% confidence interval- which means that there is a 95% probability that deviation won’t differ from the range calculated. To be sure, the exchange even adds an ELM, which estimates the likelihood of changes in value at 99%. These calculations are updated every day for margin collection and reporting.
Whenever the exchange charges margins, they collect the margin in 2 parts, i.e., Span and Exposure. Span Margin is the margin required to cover the variations associated with price, and Exposure Margin is required to cover for any M2M losses. However, industry norms say that to be completely safe, the total margin plus the M2M is necessary to carry the position. If the client’s cash balance falls below these criteria, a margin call is given to the client to deposit cash to bring to the required level. If the client fails to do so, his position is auto squared off in the market.
The usage of margin can be beneficial for the client. Let’s say a client has Rs.300000, and he wants to put that money based on his analysis in Reliance. Now, if he goes and buys in the delivery market, he gets about 157 shares @Rs1900 each. However, if he goes into the futures market, the margin for one lot of 505 stocks is Rs.250000. After this investment, Reliance zooms to Rs.1950. Let us look at both the scenarios in this case:
Case I (Delivery) – In the case of delivery, the profit accumulated by the client is Rs.7850 (50*157). This translates into a net return of 2.61% (7850/300000*100) in this position.
Case II (Futures) – In the case of futures, the profit accumulated by the client is Rs.25250 (505*50). This translates into a whopping return of 10.1% (25250/250000) in this position.
It is evident from the figures that margin is one of the most effective tools for an investor to create wealth through trading. However, we advise investors to exercise caution as if the trade goes against the client; the losses are amplified in the same way the gains are. Proper risk management and stop-loss (as discussed in our previous blog) is essential for earning consistently in trading through margins.
With this knowledge, Mr ABC has now understood how margins work and can create huge returns for the trader. He is ready to trade. I hope you are ready as well!