Risk Management In Futures and Options Trading
Most of the derivative market traders, don’t have a clear picture of margin money and how it’s different from the futures and options writing. Let us try to explain with examples. Remember one thing, the future margin is always higher than the option writing.
If you are buying or sell a futures contract, your broker will collect the initial margin. We should understand the future contract and margin management
The initial margin should be to cover the risk of adverse price movements. At the time of initiating a trade, you must pay the total required margin. There are two types of margin included in the required margin.
- Span Margin
- Exposure Margin
Exchanges collect initial margin upfront for all the open positions of clearing members based on the margin computed by the SPAN (Standard Portfolio Analysis of Risk) system.
SPAN Margin is an initial margin is calculated based on the risk and volatility of the underlying asset. There is a set of statistical formulae for the calculation. We don’t enter into the complex formulae, try to understand the basic margining system. The SPAN margin for a particular underlying asset keeps changing from time to time based on the volatility and market risk.
The Exposure margin is blocked over and above the SPAN margin for the safety of intraday exposure in the market. It’s a constant one not changed frequently. The margining system is only applicable to the future and short option position. Option buyers only pay the premium amount.
For the Index short options and futures contracts, the exposure margin will be 2% of the notional value of the futures contract.
|Underlying asset||Notional value||SPAN Margin||Exposure Margin|
Notional value calculated from the last closing price of the underlying contract multiply by its lot size. For example, last closing price of Nifty was 13750 and the lot size is 75.
Notional value of the future contract = 13750 * 75 = 10, 31,250
Thereby adding the SPAN margin and exposure margin, we get a total initial margin of around 150000 for one long future contract of Nifty future. Let’s come to option writing for the different strikes in January 2021 monthly contract.
|Strike price||SPAN margin||Exposure margin||Premium receivable||Total Margin|
From the above table, the far out of the call and put option has less margin compared to the near money option, there is not much change in the exposure margin but the SPAN margin will change for every strike price.
One more interesting thing, whenever you take the short position of any options, initially you have total margin in your trading account, and end of the day the premium received from the selling option will be credited to the same day in your ledger.
Recently SEBI (Securities Exchange Board of India) has come up with new margin rules, if you take a hedged position, the initial margin will drastically reduce. For example, long in future contracts and buy put option for hedging, the initial margin will around 50000. For your information, any hedge position has its own advantage and disadvantage itself.
One more interesting fact, if you trade in a calendar spread in future trade, exposure margins are levied on one-third of the value of the open position of the far month future contract. The benefit of the calendar spread in the exposure margin is the long position of the futures contract will be exempted from the exposure margin.
Calendar spreads are types of trades in which traders take a position simultaneously buy and sell the same future contract in different expiration months. For example, sell the January Nifty future contract and buy the February Nifty future contract.
The combined Margin requirement for a calendar spread is around 50000 only. These are the rough figures for your understanding. Before entering the trade, calculate the margin requirement from the SPAN calculator.
Our readers get a clear idea about the SPAN margin and exposure margin in futures and options trading. Remember one thing, exposure margin will be levied by broker discretion.
It’s ranged from 3.5% to 5% in stock option and 1.5% to 3% for index trades. Institutional traders avail the margin benefit of hedged position and we also advised our traders to take a hedged position to avoid huge risk in a naked position.
Options trade is a high risk, high reward game, without understanding margin calculation, don’t enter into the trade, it will end up with a huge loss along with a margin penalty levied by the exchange. BE SMART IN TRADING!