Skill Sheet: What You Will Learn Here
- What is margin in trading?
- Benefits and risks of margin in futures trading
- Different types and features of margin
- Risks of margin trading
Many traders prefer futures trading over trading normal stocks because of two major benefits. Leverage in trading and risk mitigation. In this chapter, we will talk about leverage.
What is margin in trading and the simple math of calculating leverage
Unlike purchasing stock, purchasing futures does not need complete payment. To purchase or sell a futures contract, one needs to pay a portion of the overall contract value. This payment -- called “margin” -- is basically a minimum requirement that needs to be kept at all times to continue to have the ability to trade futures contracts.
For instance, if you have to buy a futures contract of a stock which trades at Rs 1000 and which has a lot size of 1,000, you are not required to put down Rs 10 lakh. You can put a percentage, typically 20-30% of this amount as a margin.
For instance, check out the order form for Reliance Industries futures. The futures are priced at Rs 2,642, and the minimum lot size is 250 shares. This means that the contract size is Rs 6.6 lakh (2642 x 250), but the initial margin required to buy this contract is only Rs 1.45 lakh, as you can see below.
For instance, if a stock's futures margin is set at 20%, one might buy/sell 5 times as many shares in futures as in equity.
This means that your gains would be five times greater than the equity profit for every unit of stock price rise. This magnification applies to losses, too, since a 20% loss in equity means a 100% loss in futures because of the 5x leverage.
Due to the fact that leverage in trading magnifies the effects of price fluctuations, even little changes in price can produce substantial gains or losses.
To protect the sanctity of the contract and to ensure the trades will be settled without the losing party running out of funds, exchanges ensure that should a party start going into a loss in the vicinity of the margin they have put up, the trader is required to top up the margin to remain in the position. If the trader fails to provide more funds, the exchange may automatically sell the position.
Margin in stock market
The margin in the share market is different for the usual securities and for futures. It is important for us to understand the difference as traders.
To acquire and own a stock, bond, or exchange-traded fund, you can borrow up to 50% of the purchase price as a margin in the securities industry. This method is frequently referred to as margin purchasing. So what is margin in futures trading? The sum of money you must deposit and have on hand with your broker when you initiate a futures position is known as the margin in the futures markets. You do not own the underlying commodity, and it is not a down payment.
Types of Margin
Initial margin: Minimum amount requirement set out by the exchange for opening a futures position. The margin amount is specified by the exchange, but your broker could also need to get more money for a deposit. For example, suppose at an initial margin of 5%, you are buying contracts for Oil futures valued at Rs.32,500 (Rs 6.50 x 5,000 units) and may only have to post Rs 1,700 in margin, which is just 5% of the total contract value. This total amount might increase in order to cover any brokerage fees.
Maintenance margin: Minimum amount requirement set out by the exchange that must be maintained at any given time in your account. You will receive a margin call that mandates you to add funds immediately to your account to bring it back up to the initial margin level. For example, suppose the margin on contracts for Oil futures is Rs. 10,000, and the maintenance margin is Rs.7000. Then the oil futures contract to be purchased requires a minimum of Rs. 10,000 in the initial margin. If the price of oil drops enough for the value of the account to drop by Rs.3500, you will need to submit an additional Rs.3500 in the margin to bring the level back to the initial level. The margin call is eliminated if you close or sell your futures contract.
Some features of margins:
- Compared to securities acquired on margin, which can represent up to 50 percent of the face value of the security, futures leverage typically reflects a lesser proportion of the notional value of the contract, ranging from 3 to 12 percent per futures contract.
- Depending on the state of the market, margin requirements may change. In order to account for increased risk, the clearing-house margin approach may result in larger margin needs if daily price changes grow more erratic. In contrast, margin requirements could be lowered when the market and the margin technique call for it.
- If you don't or are unable to satisfy the margin call, you could be allowed to decrease your position in line with the money still in your account, or your position might be automatically liquidated if it falls below the maintenance margin level.
- Futures exchanges, not brokers, determine the margin rates for futures contracts. However, brokerage companies may charge a premium beyond the margin rate set by the exchange in an effort to reduce risk.
- Margin enables the exchange, also known as a "counterparty," to function as the buyer for every seller and the seller for every buyer of a futures transaction. As it is made in the name of the exchange, this ensures the buyer's anonymity.
How to use margin in trading and manage futures leverage risks
Use rigorous stop losses while trading futures: This is a very fundamental rule for any trading activity, but it will guarantee that you exit losing positions quickly. Is it feasible that the stock could finally reach your target price after it hits the stop loss? Yes, but as a futures trader, your top priority is to safeguard your money since. The alternative is: leverage will empty your account. Simply close out your position when the stop loss is triggered.
At regular intervals, keep booking profits on your futures investment: It guarantees that your liquidity is unharmed and that you are growing your corpus each time you book gains. This makes sure that you have more market leverage available to you. Due to the fact that you are in a leveraged position, it is equally crucial to limit your trading losses and maximize your trading earnings.
Avoid the risk of concentrating your exposure: If, for example, all of your futures holdings are in industries where interest rates are volatile, then any increase in interest rates by the RBI might have a negative knock-on effect on your trading positions. To avoid the negative effects of news flows being too severe, it is usually preferable to spread out your leveraged holdings. Keeping this in mind, it might be risky to average down when futures prices decline since you run the risk of over-exposing yourself to a certain sector or theme.
Futures traders must use sensible stop-loss orders to contain possible losses in order to manage the added leverage effectively. Good futures traders take care not to over-margin themselves and instead keep a sufficient amount of free, uncommitted investing money on hand to support equity drawdowns. Compared to typical equities investment, trading futures contracts demands more trading expertise and hands-on management. To take full advantage of the capital efficiencies that futures provide, it is important to comprehend how futures margin operates.
Points to remember:
- The margin is the minimum amount required to trade futures.
- Margin offers leverage which allows a trader to trade with more money than they have.
- Leverage can increase returns but can also lead to significant losses therefore, risk management is a must.