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How to Benefit From New Margin Framework

28 Jul 2023

Introduction

The new margin framework has been effective since June 2020, and it offers several benefits over the older system. The primary advantage of this framework is that the risk to investors is significantly reduced. The change in price scan range to 6 Sigma will also not allow margins to move suddenly, which ultimately benefits investors.

What is the new margin requirement?

In the cash market, there is no margin requirement, but if an intraday trade is being attempted, the margin requirement is 20% of the value of the trade. This is an almost 70% drop from the previous margin framework requirements. This reduced risk has brought in and continues to bring in more investors because the risk appetite does not need to be extremely high any more.

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If the buy call is not set at the higher market level, then the risk isn't capped. The naked margin then has the potential to incur unlimited losses should the market spike to unprecedented levels.

Understanding the new margin framework with an example

If the market is bearish, the standard strategy is to buy put options or short futures. This will net considerable profits if done right. But if not, the investor ends up taking unnecessary risks. What the investor can (and should) do to minimise risk is to set a spread to protect the maximum loss. 

Let’s understand this and the new margin framework with an example. 

Assume, today's NIFTY Index is currently trading at Rs 19,200. You expect that it won’t cross Rs 19,500 by the end of its expiration on August 31st. 

You decide to short Rs 19,500 call options that are trading at Rs 408. If the NIFTY stays below Rs 19,500, the maximum profit you can make is Rs 20,400 (Rs 408 x 50). Yet, the risk lies in unlimited losses if the NIFTY closes above Rs 19,908 (19500 + 408).

However, instead of a naked short option, you can opt for a spread strategy to protect you from losses. You short Rs 19,500 call options as before and also buy Rs 19,900 call options. This is where the new margin framework comes in.

The money required for this spread is Rs 35,219, against the earlier margin requirement of Rs 90,754. It means your margin benefit is Rs 55,535. 

By executing this spread strategy, you benefit from a higher margin of safety and insurance against significant market moves. To execute this strategy, remember to place the buy option trade first, followed by the short option trade. When exiting the spread position, ensure you exit the short option position before the buy options to avoid potential margin shortfall messages and the risk of position liquidation.

What are the changes in the price scan range? 

As mentioned earlier, the price scan range has changed from 3.5 sigma to 6 sigma. What this does is correlate margin requirements for naked positions with volatility in the markets. That is, the more volatile a market is, the higher the margin required. 

However, with a reduction in market volatility, the margin requirement will decrease as well. This high price scan range will only allow the margin to increase or decrease gradually, reducing the risk for the investor. 

Conclusion

The new margin framework is a significant change in the market. It will encourage new investors to enter the futures and options markets by reducing the risk traditionally associated with them. Though, it is crucial for investors to undertake detailed research before making a final call.

 

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