Margin Calculations

In an earlier post, I mentioned that during future trading you will not pay any premium and seller (sugar cane farmer) will not receive any. In spite of that the future contract will be binding on both the parties. So how does exchange ensure that both the parties maintain their side of the bargain and not run away?

It is done by charging ‘Margin’.

Margin is a percentage amount of the trade value which exchange takes from both; the buyer and the seller as good faith money. Let’s take an example; if you were to buy NIFTY future, one lot at 5000 price you would be needed to pay 250000 in normal case. However you do not have to pay full 250000 for the lot, you pay a percentage of it. This percentage varies from Index to Index, Stock to Stock and Time to Time and it depends on Underlying as well as Volatility.

This Margin is consisting of two parts. There is an initial margin which depends on price and volatility and another is exposure margin. Margin calculation is done by SPAN technology used around the globe. Its origins are credited to oldest derivative exchange CME (Chicago Mercantile Exchange). It does a complex set of calculation involving price, volatility and GOK (God only Knows) what else and arrives at a percentage number which you have to pay. Exposure margin is a fixed percentage like 3% to 5%. Both these margins are adjusted every day and you are required to pay any margin shortfall at the end of the day (EOD).

Let us illustrate this whole concept with an example.

Let’s say we buy one lot of NIFTY at 5000. Trade value is (50x5000) 250000 and SPAN margin requirement is 10% so you pay 25000 as margin. You are happy and exchange is happy. However cosmological forces conspire against you and NIFTY fall 3% (150) points during the day. At the EOD, exchange carries out following activities;

It calculates you MTM (Mark to Market) loss which is 150x50 = 7500 which you obviously have to pay. The conspiracy does not end here… Exchange also calculates new SPAN margin. This calculation takes in to account the 3% fall (which is a comparatively large move) and it increases the volatility number for NIFTY. So it increased SPAN margin to a ball park 15% now. Your margin shortfall becomes 5% of 250000 (10% you have already paid) and the amount it 12500.

So exchange, through your broker makes a margin call of SPAN Shortfall 12500 + MTM 7500 = 20000 on you which you have to pay. This payment is just for staying in your position. What bamboozles a trader is that he has to pay 80% of his initial margin (20000 on initial 25000) for a small 3% move in NIFTY. Hence your total margin becomes 45000 for the lot.

This is just about Margin calculation. I will post about how to pay the margin, can it be offered through collaterals, what happens for multiple positions (buy/sell together), what happens if you do not pay the margin and how to avoid nasty surprises. Taking cue from here, I will also write about Margins for Options on the Options Blog.

Before closing, I wish all of you and your loved ones a Very Happy, Joyous, Prosperous and Safe Diwali. Have a rocking time.