Margin Management

The initial part of this section concerns the post-trade functions when the security that is traded is a futures contract. Later in the section, we will look at margin trading for stocks.

9.8.1 Initial Margin

Before initiating trade in a futures contract, the broker collects a deposit called initial margin from his clients. Initial margin is sometimes called Original Margin. This may be in the form of cash or acceptable securities. The broker holds this deposit in an account known as margin account.

Similarly the clearinghouse requires the clearing members to maintain a deposit with it to cover the margin requirements.

The initial margin is intended to represent the maximum one-day net loss the investor could be expected to incur on a position. Thus initial margin varies with the contract in question as it depends on the volatility of the contract. Initial margins are typically based on VaR. The margin is usually calculated to cover a movement of about 3-5% in the price of the contract in a day. However it can be changed during a trading day if the situation in the market demands it. This happens when there is a very large movement in the contract price. In that case the margin is called intra-day margin.

9.8.2 Maintenance margin

Maintenance margin is some fraction—perhaps 75%—of initial margin for a position. Should the balance in the margin account fall below the maintenance margin, brokers require investors to deposit funds or securities sufficient to restore the balance to the initial margin level. Such a demand is called a margin call. The additional deposit is called variation margin. If the investor fails to make a variation margin payment, the broker will immediately liquidate some or all of his positions.

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So how does margin account actually fall below the maintenance margin? It happens because of a mechanism known as marking-to-market.

9.8.3 Marking-to-market

This is recording the price or value of a futures contract on a daily basis, to calculate profits and losses. At the end of each trading day, the profit or loss is calculated on the futures position held by the investor. If there is a loss, the broker transfers that amount from the investor’s margin account to the clearinghouse.

E.g. Suppose Hero Hiralal had bought a futures contract for Rs.100 yesterday and for some reason its market price fell to Rs.95 today. Therefore Hero Hiralal suffered a loss of Rs.5 today. As a result, his broker would have transferred Rs.5 from the margin account to the clearinghouse. Similarly, if there is a profit, the clearinghouse transfers that amount to broker who then deposits it into the investor’s margin account. This is the daily margining process. The clearinghouse's margin cash flows net to zero. For every margin payment it receives from one party, it makes an offsetting margin payment to another party.

You might have realized by now that because of this margining process, futures settle every day. So even though Hero Hiralal didn’t ask his broker to sell the futures contract, he had to sell the contract and incur the loss. In practice this selling activity takes place at the closing price is in the market, and is followed up buying the contract again at the closing price. So the investor’s position remains unchanged, but the losses / profits are real and affect the balance in the margin account.

The balance amount in the margin account is returnable to the investor when he closes his position.

Let us go through an example to understand the concepts above.

Example:

Suppose a silver trader, Chandi Tola Ram contacts his broker on June 5 to buy a silver futures contract on the New York Commodity Exchange (COMEX). Suppose the futures price is $4000/kg. Chandi Tola Ram contracts to buy 10 kg at this price. Contract size for each future contract is 1kg, so he will have to buy 10 future contracts. The broker tells Chandi Tola Ram that the initial margin is 50% of the contract size, i.e. $2000/contract, while the maintenance margin is 37.5% i.e. $15000/contract. At the end of each day margin account would be marked-to-market. Now suppose that at the end of the day, the futures prices drops to $3700/kg. Chandi Tola Ram thus makes a loss of $3000 (=10 * 300). The margin account balance therefore reduces to $17000. Chandi Tola Ram’s broker pays this $3000 to the clearinghouse (no this is incorrect, he will pay only if margin balance falls below maintenance margin). On the other hand, had the price at the end of the day been $4300/kg, Chandi Tola Ram would have made a profit of

$3000. The account balance in this case would have been $23000. The $3000 would have been transferred by the broker to the margin account. Chandi Tola Ram is entitled to withdraw this $3000 and buy gifts for his family.

Now let us take the example a step further. Suppose at the end of the day futures price is $3970 and the margin account balance is $17000. Chandi Tola Ram’s bad luck continues, and the futures price keeps on tumbling. The table below illustrates the operation of the margin account.

Day

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At the day end on 7^th June, the margin account balance falls below the maintenance margin. The broker therefore issues a margin call, and Chandi Tola Ram has to deposit $6000 to the account so that balance equals the initial margin. Similarly on 9th June, he has to deposit $5000.

Now that we have some idea of what margin means, let us look at how it can be used in stock trading.

9.8.4 Buying on Margin

Buying on margin is borrowing money from a broker to purchase stock. It allows the investor to buy more stock than he would be able to normally.

To trade on margin, the investor needs a margin account with the broker. This is different from a regular cash account that is used to trade using the money in the account. By law, the broker is required to obtain the investor’s signature to open a margin account. An initial deposit, known as the minimum margin, is required for a margin account. Once the account is opened and operational, the investor can borrow up to a fixed percentage (usually 50%) of the purchase price of a stock. The portion of the purchase price that the investor deposits is known as the initial margin. The investor does not have to borrow all the way up to 50%. He can borrow less, say 10% or 25%.

The investor can keep the loan as long as he wants, provided he fulfils the obligations. First, when the investor sells the stock in a margin account, the proceeds go to his broker against the repayment of the loan, until it is fully paid. Second, there is also a restriction called the maintenance margin, which is the minimum account balance the investor must maintain. If the margin account balance becomes lower than the maintenance margin, the broker issues a “margin call”. This is a notice that asks the investor to add funds to the margin account. The broker has the right to liquidate the position if the investor does not honour the margin call i.e. the broker can sell the investor’s stocks to ensure that the account balance is greater than the maintenance margin.

Borrowing money isn't without its costs. Marginable securities in the account are taken as the collateral.

Interest also has to be paid on the loan. Over time, the debt level increases as interest charges accrue against the investor. As debt increases, the interest charges compound further, and so on.

Therefore, buying on margin is mainly used for short-term investments.

Example:

Assume that Mr. Chandan Churiwal, an investor, deposits Rs.10,000 in a margin account. Because he puts up 50% of the purchase price, this means he has Rs.20,000 worth of buying power. Then, if he buys Rs.5,000 worth of stock, he still has Rs.15,000 in buying power remaining. He has enough cash to cover

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There is an important learning here: the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account.

Buying on margin increase the “leverage” i.e. the possible gains (in case of favourable outcome of investment) and losses (in case of unfavourable outcome of investment) increase significantly. Let us understand this by continuing the above example.

Suppose Mr. Chandan Churiwal decides to invest Rs.10,000 in shares of Hindustan Lever Limited without utilizing a margin account. The current market price is Rs.100/share, so he buys 100 shares. After one month he needs to purchase a TV and decides to sell the shares. If the share price then is Rs.110 (i.e.

favourable outcome of investment), Chandan makes a profit of Rs.10/share, and overall profit of Rs.1000.

On the other hand, if the share price is Rs.90, i.e. unfavourable outcome of investment), Chandan makes a loss of Rs.10/share, and overall loss of Rs.1000.

Now let us see what would have happened had Chandan decided to buy on margin. He could have originally bought 200 shares since the market rate was Rs.100 and his buying power was Rs.20,000.

After one month if the share price then is Rs.110 (i.e. favourable outcome of investment), Chandan makes a profit of Rs.10/share, and overall profit of Rs.2000. On the other hand, if the share price is Rs.90, i.e. unfavourable outcome of investment), Chandan makes a loss of Rs.10/share, and overall loss of Rs.2000. Thus the potential profits and losses doubled when Chandan decided to buy on margin. For the sake of simplicity, we did not consider the interest charges in this example in case of buying on margin.

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