Trading Strategy – Margining System in Derivatives


Why are margins required to be paid in Derivatives Segment?

The stock exchange acts as legal counterparty to every transaction effected in the Derivatives Segment. Thus, if the party who loses fails to pay up, the exchange is legally bound to effect payments to the party who has made profits. To ensure that it can meet these commitments, the exchange levies margins on most players in the Derivatives Segment.

What kind of margins are applicable?

In India, two kinds of margins are applicable – Initial Margin payable at the point of entering into derivative transactions and Mark to Market Margins payable on a daily basis thereafter. Both these margins are calculated using a special software program called SPAN, which was developed by the Chicago Mercantile Exchange. Hence, margins are also called SPAN Margins.

Who needs to pay margins?

Futures buyers, Futures sellers and Option sellers need to pay margins. Option buyers need not pay any margins, as Option buyers maximum losses are restricted to the premiums which they pay for anyway upfront. They cannot be more losses than the premiums and hence no margins are required.

How are Initial margins on futures calculated?

Futures margins are based on the volatility of the scrip. The formula applied is 3.5 times daily volatility in case of stock futures and 3 times daily volatility in case of index futures. Volatilities are updated on the NSE India website every day and can be reviewed by players.

For example, if the daily volatility of Satyam is 4%, Satyam futures will attract 14% margins. Both buyers and sellers are charged equal margins in the futures market. This level is the Initial Margin.

How is Mark to Market Margins on Futures calculated?

Thereafter at the end of each trading day, Mark to Market Margins will be worked out. One party will make a profit and the other party will make an equal loss. For example, if you bought 1,200 units of Satyam Futures at Rs 226 each and the closing price comes to Rs 228, you have made a mark to the market profit of Rs 2. The party who has sold these Futures to you has made a loss of Rs 2. Thus, you will receive Rs 2 while the seller will pay Rs 2 through the exchange.

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How are Option Margins calculated?

Option Margins are calculated by SPAN. SPAN imagines 16 scenarios of changing price and volatility levels in the underlying. It then works out the losses which the seller can suffer in each of the 16 scenarios. It then considers the worst of these 16 scenarios and calls upon the seller to pay margin equal to this maximum possible loss.

How are the 16 scenarios defined?

SPAN works out a parameter called ‘Price Scan Range’. This is worked out as Price of the underlying multiplied by 3.5 times Daily Volatility. For example, if Satyam price is Rs 230 and the Daily Volatility is 4%, the Price Scan Range will be Rs 32.20 (230 x 4% x 3.5).

Another parameter is the Volatility Scan Range which has defined as 4% in India by SEBI.

16 scenarios are then defined applying Price Scan Range and Volatility Scan Range. In the Price column in the following table, Up 1/3 means 1/3rd times the Price Scan Range and so on. Volatility Up means up by 4% as defined by SEBI.

Scenario Price Volatility Weight
1 Unchanged Up 100%
2 Unchanged Down 100%
3 Up 1/3 Up 100%
4 Up 1/3 Down 100%
5 Down 1/3 Up 100%
6 Down 1/3 Down 100%
7 Up 2/3 Up 100%
8 Up 2/3 Down 100%
9 Down 2/3 Up 100%
10 Down 2/3 Down 100%
11 Up 3/3 Up 100%
12 Up 3/3 Down 100%
13 Down 3/3 Up 100%
14 Down 3/3 Down 100%
15 Up 2 times Unchanged 35%
16 Down 2 times Unchanged 35%

The values of the Options sold are worked out applying the Black Scholes Model for each of the 16 scenarios and the scenario generating the maximum loss is taken as the margin amount payable by the Seller.

As the probability of the scrip going up or down by 2 times the price scan range is very low, the weighting factor applied to the 15th and 16th scenarios are only 35%. Thus, if the loss due to the scrip going up is say Rs 50, then for the purpose of the margin, SPAN will consider only Rs 17.50 (i.e. 35% of Rs 50).

Are there any minimum margin stipulations regarding SPAN Margins?

Yes – SEBI regulations require that a minimum margin of 3% of the notional contract value should be applied if SPAN margins work out to lower than 3%.

Are there limits on the volume that can be transacted by any player in the market?

Yes, there are limits at three levels – one – market-wide limit – open interest of the total market cannot exceed specified limits – two – trading member limit – the maximum limit of exposure which any trading member can go up to – and three – client limit – the maximum exposure which any client can go up to.

Are there margin implications of these limits?

Yes – if market wide open interest exceeds 80% of the market-wide limits, then margin payable is twice the SPAN margin level. Further, if market wide open interest exceeds 90% of the market-wide limits, then margin payable is thrice the SPAN margin level.

As a retail investor, you need to keep watch of market-wide limit positions and be aware that margin requirements may suddenly double or triple. Investors may be forced to square up in a hurry if they cannot pay such high margins at a notice of practically one day.

How are these limits defined?

In our next article, we will take the definition of the limit and also take up a numerical example of SPAN calculations.

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