Mark to Market (M2M), Margins & Margin Calls in Futures Trading

Know about Mark to Market (M2M), Margins, Span Margin & Margin Calls in Futures Trading

The role of margins in future trades is indispensable. An investor can take the benefit of leveraging in their future trades.

For this, they must use the capability of margins to derive the benefit. It is necessary to understand how margins impact a future trade. This helps an investor in an application for trading in the market.

As already discussed in the previous articles, the margin is a small margin of the total contract value of future trade.

It allows an investor to make a small outlay while entering a larger contract value, using the concept of leveraging.

What is Mark to Market (M2M)?

It is no big news that the price of every futures security fluctuates on a daily basis. Due to this, every trader stands to make either a profit or a loss for the contracts which they have entered into.

Mark to market (M2M) is a type of accounting procedure which adjusts the profit or loss for each day and entitles it to the trader.

For as long as the trader continues to hold the futures contract, the concept of M2M will remain applicable.

Let us take an example to elucidate this matter. Let us assume that on 1st January you decide to buy ABC stock at a rate of INR 165 for a lot size of 2000.

After 4 days on 4th January, you decide to square off your position at a price of INR 170.10. It is clear that this trade will result in a profit for the investor for an amount of INR 5.1 for each stock.

The total profit which accrues to the investor will be 2000*5.1 which is INR 10200 However, let us go back a little and scrutinize the interim of the 4 days for which the stock was held.

For each day while the trader continues to hold the stock, the profit or loss resulting from it is marked to the market.

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Example of Mark to Market (M2M)

So, let us go through the concept for each day. On day 1, the price of the stock at which you purchased it was INR 165.

Let us say that today the price of the future stock went up to INR 168.3. Clearly, you have made a profit of INR 3.3 for the present day.

This means a total profit of INR 6600 on a lot of 2000 shares. To fulfil its task, the exchange will ensure that this amount of INR 6600 is credited to your account on the same day.

This money comes from the counterparty to the contract who will pay for their loss. Now, on the next day, the buying price of the trade will be INR 168.3 and not INR 165.

This is because the profit resulting from the initial buying price is already settled. Now let us say that on day 2 and 3, the price of ABC futures is INR 172.4 and 171.6 respectively.

While the trader will again make a profit on day 2, it will be a loss on day 3. Thus, it is possible to make a greater profit during the time that you hold the trade.

But ultimately, your final profit will be calculated only after adjustment of the loss towards the trade.

To sum up, mark to market is a concept where the money is either debited or credit to the account of a trader. This is why it has come to be known as a daily obligation.

Depending on the behavior of the future price, each day the price of the previous day serves as a base for calculating the profit or loss.

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Concept of Margins in Futures Market

If we look at the foundation of a forward’s contract, we will find that there is no legal base to support the contention of both parties.

However, in the case of a futures contract, it is an exchange that takes forward the agreement between two parties.

Thus, the presence of exchange ensures that the parties do not have to undergo the risk of default from the other party.

So, an exchange basically makes sure under all circumstances that each party receives its dues from the other party. It does this by two means.

One of them is by collection margin money and the other is through marking daily profits and losses to the market.

What you should know is that margin is an amount which a trader blocks with the exchange at the time of taking a position in the futures trade.

This part of the margin which is blocked by the exchange is the amount of initial margin. The initial margin is further divided into two, the span margin and the exposure margin.

Usually, the exchange will block the initial margin in your Demat for as long as you continue to hold the futures contract.

This level of initial margin continues to vary on a daily basis due to the changing requirements of the futures market.

Understanding Margins

Now, with the knowledge of M2M, we can look at margins differently. So far, we know that at the time of entering into a futures trade, you need to pay an initial margin.

This amount of initial margin is the equal of span margin and exposure margin. In the event of failure to fulfil the obligation owed by the trader, the broker and the exchange involved in the trade, stand to suffer.

This calls for a token of insulation for both, the broker as well as the exchange. This happens with the help of a margin deposit which adequately covers the interests of both.

Thus, a span margin is a margin which cushions the risk of the exchange. While the exposure margin protects the broker against the risk of default by the trader.

The exchange will initially specify the span and exposure margin for each stock. So the trader can decide his positions accordingly.

It is absolutely necessary for a trader to adhere to the margin requirements at the time of taking a position in the futures trade.

The exchange will then block the complete amount of initial margin for the purpose of trading. Out of the two components of the initial margin, the importance of span margin is certainly greater.

This is because a default on the span margin will imply attachment of a penalty by the exchange itself.

Sometimes, span margin is also known as maintenance margin. The reason for this is because the trader will have to maintain it as long as they wish to carry their position for the next trading day.

Calculation of Span Margin by Exchanges

You might be wondering how an exchange calculates the span margin requirement for each stock on each day

Doing this on a daily basis requires the use of an algorithm. It loosely makes use of various elements such as market volatility to decide this margin requirement.

There is a direct relation between volatility and span margin. So, if volatility were to go up, the span margin would also increase.

On the other hand, the exposure margin generally varies between 4% – 5% of the amount of contract value. Let us take an example to comprehend the idea of M2M and margins.

Understanding How Margin Requirement Works

Further, take a look at the day to day prices of the stock. We can easily arrive at the value of INR 4075 and understand how the margin requirement works.

The total profit or loss resulting from this trade can be calculated by a number of methods.

• Taking the sum of all M2M’s
  = 325 – 250 – 2250 + 4750 – 4000 – 2000 + 3250 + 4250
  = INR 4075
• Calculating the cash release
  = 33409 – 29334
  = INR 4075
• Difference in value of contract
  = 238750 – 234675
  = INR 4075
• Using futures price
  = 250 * 16.3
  = INR 4075

What is the logic behind charging Margins?

To understand the concept of margins, let us give you an example. It is the instance where a trader A planned to purchase copper from B. In our example, the agreement occurred for a quantity of 15 kg copper at a price of INR 1550.

We saw that even a slight increase or decrease in the price of copper in the market held the potential to affect A and B and their returns.

If the price of copper increases, B stands to make a loss. Similarly, if the price of copper falls, A stands to make a loss.

Now, consider a situation where the price of copper rises by a very sharp margin. It is possible that B may default on their word in this situation. This will surely be a huge loss to A who might have to take the legal path to seek a solution.

Thus, we can say that in a forward’s agreement, the incentive and scope to make default is quite high. Now, futures markets happen to be an extension of the forwards market.

Thus, it is necessary to deal with this potential default angle and avoid it. We can say that the role of a margin comes into effect at this exact point.

What is a Margin Call?

Let us assume that the trader decides to carry forward the trade for another day to 20th January. On this day, ABC falls down heavily by 8%. This carries the price of the security down to INR 880 from INR 955.

In this case, the M2M loss will amount to INR 18750. It will be the difference between INR 955 and INR 880 * 250.

The cash balance will be INR 14659 now and since the price drops, the new contract value will be INR 220000.

This can be divided into a span margin of INR 16500 (7.5% * 220000), exposure margin of INR 11000 and the total margin of INR 27500.

It is clear that the cash balance of INR 14659 is less than the span margin of INR 16500. In this case, the broker will have to call the trader to introduce more money into their account.

Sometimes, they may even go on to cancel the trade on their own.

To Conclude Mark to Market & Margins in Futures Trading

For the duration during which the futures trade is alive, the margin requirement will continue to exist. Initial margin further filters into span margin and exposure margin.

The margin requirements are decided by the exchange from time to time. It is important for a trader to maintain the margin requirements in their account otherwise; the broker may cancel their trade.

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