When you buy or sell a futures contract, why are you required to pay margins? The answer is that futures trading involve risk because the price movement could go against you. When you buy futures of the Nifty at a level of 10,300 and if the Nifty goes down to Rs.10,200 there is a loss you are incurring and that is your risk. Markets are by nature volatile and these margins are essentially collected to cover this volatility risk. So, how does futures margining work? Broadly, there are 2 types of margins that are normally collected. At the time of taking the position you are required to pay the Initial Margin on the position (SPAN + Exposure margin).
The SPAN margin is based on a statistical concept called VAR (Value at Risk). It basically means that the initial margin should be large enough to cover the loss of your position in 99% of the cases. There will be Black Swan days but that is a different issue. Initial margin is based on the potential maximum loss in a single day on the portfolio. Greater the volatility of the stock, greater the risk and therefore greater is the initial margin. The second type of margin is the mark-to-market (MTM) margin which is collected for daily volatility in the price of the futures. The initial margin only looks at single-day risk. If the stock continues to move against you (falling when you are long / rising when you are short), then on each subsequent day the MTM will be collected. So how does futures margin work in practice? Let us understand all about margins on futures contracts through a live example of Initial Margins and MTM margins..
How Initial Margins are calculated?
The chart above calculates the initial margin as a sum of the SPAN and the Exposure margins. The minimum margins required for each specific position are defined by the stock exchange. Brokers are free to collect more than this margin but they are not permitted to collect less than this margin. In the above table, the Nov, Dec and Jan contracts of ACC are considered. You will find that as the contract goes farther into the future the margins are higher due to higher risk. But what is important here are the 3 classes of initial margins that are charged by the broker on your futures position. Let us understand the nuances of this futures margin example..
Carry Forward (Normal Margin):
This is the normal margin that will have to be charged when you propose to carry forwards your futures position beyond the day. Normally, in case of Carry Forward trade the initial margin varies from 10% to 15% of the notional value of the contract depending on the risk and volatility of the stock. In the above case, for the Nov 2017 contract, the notional value of the futures contract is Rs.708,580/- (1771.45 X 400). On that notional value, the initial margin is collected at Rs.89,338/- per lot, which works out to 12.61% of the notional value. As mentioned earlier, this percentage of initial margin for the futures position will depend on the volatility and risk of the stock.
Intraday (MIS) Margin:
The normal margin pertains to a futures position which you propose to carry forward to the following day. However, what if you want to square off the position intraday? Since the risk is lower, the initial margins (MIS) will be lower. For Intraday index futures the initial margin is set at 40% of the normal initial margin while in case of intraday stock futures the initial margin is set at 50% of the normal initial margin. In the above case, the margin will be 50% of the normal margin which is Rs.44,669/-. This margin is referred to as Margin Intraday Square-off (MIS) margin.
CO / BO order Margin:
The third category which is even lower than the MIS margin is the BO/CO margin. These are the Bracket Orders and Cover Orders. In a cover order the intraday trade is necessarily set with an in-built stop loss. The Bracket Order goes a step further and defines the stop loss and also a profit target making it a closed bracket order. The margin in this case will be 30-33% of the normal margins and in the case of ACC it is Rs.28,343/-
One thing you need to remember is that in case of MIS orders, CO orders and BO orders all open positions will normally be closed out by your broker’s risk management system (RMS) 15-30 minutes before the close of stock market trading on the same day.
Mark to Market (MTM) margining:
Mark to Market (MTM) margin is an accounting adjustment. If you have bought the futures of Tata Motors at Rs.409 and as long as the price is above Rs.409, you really do not have much to worry. The MTM problem will come when come when the market price of Tata Motors goes below Rs.409. Here again there are 2 situations. Firstly, if the price goes down to Rs.407, most brokers will check if your margin balance is sufficient to cover the SPAN margin. (Remember Initial Margin is SPAN + Exposure Margin). That is still OK. However, if the stock price goes below say Rs.395, then your margin balance is likely to fall below the SPAN Margin. Then the broker will make a Margin Call asking you to fill up the deficit in margin and if you are unable to pay the margin then your position will be closed out by the RMS. Remember, MTM margins are only applicable to carry forward positions and not to intraday, BO or CO positions.
So, that is all about margins in futures contracts. The futures margins example above clearly highlights how do futures margins work in practice. In a nutshell, it is a risk management measure!