Various types of Margins

In the previous chapter, we discussed how to hedge the market risks through the usage of various types of derivatives such as futures and options. Now let us now talk about different kinds of margins that are necessary in derivatives.

Understanding margin requirements is important for trading in derivatives. A margin is a security deposit for ensuring that the trader has enough balance with himself to take care of the financial obligations arising due to unfavorable market movements. With the emerging business of derivative trading, knowledge of various kinds of margins would help you manage risk well.

What is Margin in Derivatives?

In the case of a derivative trade, margin refers to the required percentage of the value of the contract that a trader needs to deposit with his broker or the exchange. It acts like collateral to guarantee the traders against the potential loss. Without margin, trading in derivatives would be highly risky because there would be no assurance of payment in case the market moves against the position.

Types of Margins in Derivatives

1.Initial Margin - IM

The Initial Margin is the amount that is required to enter a position. A percentage of the value of a contract depends on the type of derivative, volatility of the underlying, and market conditions.

The span margin or the initial margin for futures contracts generally ranges between 3-15% of the contract value and varies with the underlying asset. In the case of options, it depends upon the premium and the risk involved.

Example: If you want to enter into a future contract of a stock whose value is ₹1,00,000, and the initial margin is 10%, then you will have to deposit ₹10,000.

2.Maintenance Margin - MM

The Maintenance Margin is the minimum requirement to maintain a position. In instances where the balance, because of market fluctuations, falls below the level, the trader must deposit an additional amount because of a margin call that will bring the balance again to the level of the initial margin. It assures a trader that his position shall be covered in cases that may lead to a possible loss.

The maintenance margin is generally less than the initial margin but it is prescribed by the exchanges so that a position of the trader can be sufficiently covered or secured.

3.Mark to Market Margin - MTM

The Mark to Market Margin will readjust the margin requirements every day against the market value of the position. In such a case, when the value of the underlying asset changes, the margin is recalculated by including unrealized profits or losses. This way, it will be assured that traders hold sufficient collateral to cover any potential change in the value of their opened positions.

Example: If the value of your futures contract increases, you could have a positive MTM margin, which would lower your total margin requirement. And if the position loses value, the MTM margin may increase, requiring you to deposit more funds.

4.Exposure Margin

Exposure Margin is an additional margin that brokers or exchanges require to cover the risk exposure in very large positions, especially in volatile markets. It's a cushion for sudden changes in prices that may cause a loss to such a huge extent that the trading party will not be able to bear it and might even go to the extent of default. The exposure margin in India is normally used when the investor has large positions and goes up with increased volatility.

Conclusion

Understanding margin requirements is the safety net, keeping the market in order. The various regulatory bodies, including SEBI and exchanges, fix margin levels, and all traders must adhere to this. Whether you are an experienced trader or a beginner, being at the top of margin rules is the key to successful trading. Next, we'll dive into some risk management strategies that can help protect your investments in the dynamic world of derivatives.