Margin Mechanism In Exchange Traded Derivatives

Trading in the derivatives market can be very risky. The same is the case with Margin Trading. It is contrasting to know that while trading in exchange-traded derivatives using margin mechanism, both the exchange and the brokers manage to evade the risks involved in both of these trading methods which they would have to otherwise face if they were used separately. This mechanism may seem complicated in the first go. Let us look at how exactly this works. 

What is Margin Trading

When we borrow money from our broker for trading purposes, it is known as Margin Trading. Here are some steps to begin with Margin Trading:

1. First, you need to open a Trading account and request for Margin Trading. What is a trading account? It is essentially a link between you and your broker. 
2. You will have to maintain margin equity in your Margin to be able to use Margins. Margin equity is the minimum amount that is there in your margin account either as cash or some other security, which acts as collateral for the loan/margin provided to you by your broker. 
3. Suppose you make a trade using margin, and then you book a loss. If the amount present in your margin account goes below the margin equity level, your broker will make a margin call. A margin call is made by the broker asking the account holder to deposit money to balance the margin equity.
4. If you make a trade using margin, and you book a profit, you simply have to return the margin amount along with the interest rate and some fixed charges as specified by your broker. 

What are Derivatives

In simple words, a derivative can be any type of security, whose price is not determined by the market but by 2 or more individuals/groups based upon some underlying asset. Derivatives are of 2 types:

1. Over The Counter: The sale or purchase of these kinds of derivatives does not involve any exchange. Exchange here means authorities like the National Stock Exchange(NSE) or the Bombay Stock Exchange(BSE). 
2. Exchange-traded derivatives: Exchange-traded derivatives involve the exchange. This means the underlying value is agreed upon by the exchange as well.

The Mechanism

Let us now see how the combination of Exchange Traded Derivatives (ETD) and Margin Trading works:

During an ETD transaction, the margin is provided by the exchange itself. It is important to note that only a few certified brokers are there, to whom the exchange provides a margin for ETD. This margin is then used by the broker to lend money to the trader. Thus, we can say that a broker acts as a mediator between exchange and trader. 

As the broker is not utilizing the margin directly, whenever there is a margin call from the exchange, the broker simply passes it on to the trader. Due to this, all the losses incurred during an ETD transaction are borne by the trader itself. This reduces the risks associated with Margin Trading and Derivatives Trading for the exchange and the broker to a great extent. 

Conclusion 

Margin trading is the process when a trader borrows money from the broker for trading purposes. In case of booking a loss, the trader has to respond to a margin call as soon as possible to balance the margin equity. Derivatives are securities whose values are not decided by the open market, but by two or more individuals/entities based upon some underlying asset. Both margin trading and derivatives trading are very risky trading methods. However, exchanges and brokers minimize the risks by allowing the use of margin to the brokers for trading derivatives. When this happens, all the losses incurred during trading are borne by the trader himself.