If you are getting in derivatives trading, you would often come across these terms - margin and leverage. These terms form the core of trading futures and options. It is important to understand them since you will need to have margin and leverage to manage risk properly and make the best decisions for investment. In this blog, we explain margin and leverage in simple words along with examples that will give you a clear idea of these two terms.
What Are Derivatives?
Before discussing margin and leverage, let's briefly summarize what derivatives are. Derivatives are financial contracts whose value is derived from an underlying asset, such as stocks, commodities, currencies, or market indices. Common types of derivatives include futures contracts and options contracts.
What is Margin?
Margin is the amount of money you need to place with your broker to open and maintain a leveraged trading position. You may think of it as a deposit to ensure you have sufficient funds to cover potential losses.
Types of Margin
Initial Margin
The minimum amount of money required to open a position.Maintenance Margin
The minimum account balance that you must maintain to keep the position open.
Now you want to buy a futures contract for 100 shares of a company trading at ₹1,000 per share. The total value of the contract is ₹1,00,000 (₹1,000 x 100 shares). If the broker's initial margin requirement is 10%, you'd need to deposit ₹10,000 to open the position.
What is Leverage?
Leverage allows you to control a large position in the market with a relatively small amount of capital. It's essentially borrowed funds provided by the broker to increase your trading capacity.
Leverage Ratio
The formula used in finding the leverage ratio is:
Leverage ratio = Total Value of Position/ Margin Needed
Using the previous example, you're controlling a ₹1,00,000 position with just ₹10,000. This gives you a leverage ratio of 10:1.
How Margin and Leverage Work in Tandem
You use leverage when you trade derivatives on margin. This amplifies the potential of both making a profit or incurring a loss.
Continuing with the example shared above.
Scenario 1: Profitable Trade
- Market Movement: The stock price goes up from ₹1,000 to ₹1,100.
- New Position Value: ₹1,10,000 or ₹1,100 x 100 shares.
- Profit: ₹10,000 on a ₹10,000 investment, which means you made a 100% return.
Scenario 2: Unsuccessful Trade
- Market Movement: The stock price comes down from ₹1,000 to ₹900.
- New Position Value: ₹90,000 or ₹900 x 100 shares.
- Loss: ₹10,000, which represents 100% of your initial margin.
Margin Calls and Liquidation
When your account equity falls below the maintenance margin because of unfavourable movement of the markets, your broker will make a margin call requesting you to infuse more funds.
Example:
If the maintenance margin is 5% (i.e.₹5,000 basis the example shared) and if the account balance falls below this amount, you need to add more funds to the account. Failing to do so may lead the broker to liquidate the position to recover the losses.
Benefits of Using Margin and Leverage
Increased Purchasing Power: Leverage provides a facility to enter into more substantial trades than one's capital might otherwise allow.
Potential for Higher Returns
Profits can significantly increase compared to unleveraged positions. Diversification
With more capital you have the option to diversify your portfolio.
Margin and Leverage Risks
Amplified Losses
Losses get amplified just as much as profit, maybe even more than an initial investment.Margin Calls
Market movements can send margin calls, requiring one to add funds or liquidate the position.Interest Charges
Trading on margin can also incur interest charges against the borrowed amount.Volatility in the Market
With higher leverage, your position is more susceptible to volatility in the market.
Real-Life Scenario
You wish to trade in crude oil futures. The contract value for crude oil futures is ₹5,000 per barrel, and a contract size is 100 barrels. Therefore, the total value is ₹5,00,000. A margin of 10% will attract ₹50,000.
Potential outcomes:
- Price Moves Up to ₹5,500: This position is now worth ₹5,50,000. Your profit is ₹50,000 a 100% return on margin.
- Price Moves Down to ₹4,500: You now have a position i.e. worth ₹4,50,000. Your loss is ₹50,000 i.e. your entire opening margin.
Regulatory Requirements
While the regulations regarding margin and leverage vary by market, it goes without saying that you are always bound by local legislations and the terms provided by your broker.
Margin and leverage are the most powerful instruments in derivative trading that can definitely increase your trading potential. Both can provide opportunities for high returns but will also increase risk. With a good understanding of how they work, with sound risk management, you can leverage margin and leverage to your advantage. Happy Trading.