In the financial market, higher capital implies higher profit potential. However, investing a significant amount might not be financially viable for most investors. For this reason, they turn to derivatives, as they can purchase expensive contracts without paying the entire capital themselves. A derivative is a financial instrument that derives its value from an underlying asset, such as stocks, commodities, or indices. Usually, it comes in the form of a contract, allowing investors to speculate on price fluctuations without directly owning the asset.
The two most common types of derivative contracts are futures and options.
- Futures contract: A futures contract is an agreement where the buyer commits to purchasing an asset from the seller at a specified price in the future.
- Options contract: An options contract offers the trader the right, not the obligation, to buy or sell an asset at a fixed price.
Investors utilise margin to leverage and buy contracts over their budget in options trading. But before we proceed to talk about futures trading through margin and Mark-to-Market, let us first understand the concept of margin.
How does margin work in trading?
In margin trading, investors can buy stocks exceeding their available funds. You must deposit a percentage of your total value, known as the margin requirement, with the stockbroker. In return, you can pay a small percentage of the stock’s price to buy them while the stockbroker pays the remaining price.
Until you pay back the margin amount with interest to the broker, your securities will be held as collateral. If the profit you make after selling the stocks is more than this margin amount, you make a profit.
Types of margin
Typically, stockbrokers charge two types of margins.
- SPAN margin: SPAN Margin is an initial deposit or margin collected by the stockbroker from investors trading in futures and options.
- Exposure margin: In addition to the SPAN Margin, stockbrokers collect the Exposure Margin for settling any MTM losses.
What is MTM?
Mark-to-Market in futures trading involves reevaluating open contracts towards the end of the trading day to calculate profit or loss due to underlying asset price changes. It entails comparing the contract's entry and current market prices and settling the resultant profit or loss in the trader's account.
Also known as Mark-to-Margin (MTM) in trading, these calculations are done every day based on the closing price. The P&L is settled to the trading account on the same day.
Understanding the nuances of mark-to-margin (MTM)
Buyers and sellers can make profits or losses based on the futures contract prices, which fluctuate every day. The initial margin (SPAN Margin + Exposure Margin) is adjusted by Mark-to-Margin to settle the profits and losses and helps us evaluate if we need more margins.
Let us look at an example to better understand the meaning of MTM and how it works. Let us assume that you purchased the futures of XYZ enterprise at Rs. 200 with a lot size of 1000 and squared off your position after 3 days. Here are the closing prices for these days.
Day 1: Rs. 210
Day 2: Rs. 205
Day 3: Rs. 220
After 3 days, you would have made a profit of Rs. 20,000 without MTM. However, the profits and losses are settled at the end of every day because of Mark-to-Margin. Hence, on the first day, you will make a profit of (210-200)*1000 = Rs. 10,000. You will receive this amount in your trading account on the first day. The same amount will be withdrawn from the initial margin blocked by the stockbroker.
On the second day, you will incur a loss of (210-205)*1000 = Rs. 5,000. This is because the futures contract’s price is considered Rs. 210, and the difference of Rs. 10 for 1,000 shares has been deposited in your account.
On the third day, you will make a profit of (220-205)*1000 = Rs. 15,000. This amount will be credited to your trading account.
How does the margin call occur?
While you’ve now understood what MTM is in trading, what do you do when you have to pay a specific amount, but the balance of your margin account falls short? This is when the margin call will be made. In simple terms, the stockbroker will make the margin call when the initial margin balance falls below the maintenance margin level. At this point, you will have to deposit additional funds to meet the margin requirement. If you fail to do so, the broker can terminate the position to recover the loss.
Conclusion
Mark-to-Market effectively mitigates trading risks by settling profits and losses on a daily basis. This minimises the risk of erasing gains made in one day with subsequent losses over the next few days. Daily profit realisation helps in tracking progress and allows you to square off your positions upon achieving investment goals. This proactive approach aids risk management, enabling exit point identification after incurring losses.
