Stock futures have become an extremely popular product in the last few years. Many investors have been trying to compare the relative benefits of margin trading via stock futures trading. In both cases you pay a margin and take a much larger position than what you can afford with the liquidity available at your disposal. Here are 10 things you need to know when you do a relative comparison of futures trading versus margin trading.
10 things to know while comparing futures trading with margin trading.
1. In margin trading it is you who are the legitimate owner of the stock. Therefore, any corporate actions in the form of dividends, rights and bonuses will accrue to you. As a shareholder you will also have voting rights just like any shareholder. On the other hand, the holder of a futures position is just taking a view on the direction of the stock and hence is not entitled to corporate actions or any voting rights.
2. Both are technically similar positions. In margin trading, you put in a certain margin and then the broker funds the balance. Normally, the margin is about 20-25% with the balance being funded by the broker. In case of futures trading, your margin will be around 15-20% of the value of stock and the futures that you hold will be a derivative of the stock position.
3. In a futures trade there are only two parties. There is the buyer of the future and the seller of the future. Margin trading, however, becomes a tri-partite transaction with the financer of the transaction that provides margin funding also becoming a part of the transaction. Often, the financing entity is a group company of the broker.
4. Futures are subject to initial margins that must be paid at the time of initiating the position. If the price movement goes against you then your broker will call on you to deposit mark-to-market (MTM) margins to compensate for the negative price movement. In case of margin trading, there is no concept of MTM margins. However, the financer can place a margin call upon you to infuse more margins to compensate for the negative price movement.
5. When a futures position gets close to risky levels i.e. the client is not able to meet the MTM margins, the broker is authorized to close out the futures position and debit the losses to the client account. In case of a margin trading position, the financer has the authority to dispose the shares held in Demat if the client is not able to bring in the margin call. In the past, we have seen instances of companies like GTL and Gitanjali Gems where the stock prices crashed rapidly after the banks chose to dispose the promoter’s hypothecated shares.
6. There is also a difference in the list of stocks included in margin trading compared to futures trading. The regulator permits futures trading only in stocks that meet basic criteria of profitability, track record and liquidity. In case of margin funding, brokers have the leeway to expand the list to include more stocks. That leads to clients veering towards margin funding in cases where futures trading is not available. However, in the interests of safety and sustainability, most brokers tend to maintain a very limited and conservative margin trading stock list. Unlike the futures market, where the list is determined by the regulatory, in case of margin trading the broker has the leeway to work out the finer details.
7. Margin trading has an advantage in terms of the period to which the position can be carried forward. Futures trading are restricted to a maximum of 3 months. Often, only the current month futures are liquid enough. Hence if you propose to carry forward the position for a longer period, then margin trading may be a better option as futures trading may entail a higher cost in the form of rollover costs.
8. The second advantage that margin trading has over futures trading is that there is no minimum ticket size for margin funding. For example, in futures trading your basic lot size is Rs.5 lakhs and SEBI may look to make this more stringent to protect the interests of retail investors. Margin trading, therefore, allows clients to take much smaller positions through leverage.
9. The one important difference you need to remember is that when you opt for margin funding, you pay interest on the amount funded. On the contrary, when you opt for futures trading, there is no interest payable by you. Of course, you do indirectly pay interest when you opt to roll over your position to the next series. A rollover cost is nothing but reflective of the interest cost payable by the borrower.
10. Finally, we come to the of discussed topic of unlimited profits on both these products. While that is theoretically true, there is a counterargument to it. Just as profits can be magnified in margin trading and futures trading, the losses can also get magnified. To cite an example, when you are leveraged 5 times in the market, a 10% negative movement in the price can result in 50% erosion of your margin money.
Both margin trading and futures trading are excellent products where you have high conviction but want to use leverage smartly. You need to remember that when you are leveraged, the magnification of returns works both ways.