Why is Higher Than Usual Margin Blocked For F&O Trades Close to Expiry
Introduction
Futures and options are financial instruments that allow you to speculate on the expected price movements of underlying assets.
A future is a contract between the buyer and seller to trade the underlying asset at a predetermined price and date. In contrast, an options contract grants the buyer the choice, without any obligation, to purchase or sell the underlying asset at a specific price before the contract's expiration.
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What is the role of delivery margins?
Delivery margins play a crucial role in the increased margin requirements near expiry.
They are imposed on all possible positions that can be physically delivered, beginning four days before the expiration date. They are applicable even if no charges are incurred during the acquisition of such positions. This continues until the positions are squared off before expiry or settlement is completed after expiry.
Why do margin requirements increase near expiry?
As F&O contracts near their expiry date and approach physical delivery, their required margins increase proportionally to their contract value. This is because physical settlement requires the actual delivery of the underlying asset. Hence, higher margins are blocked for F&O trades to ensure that you have sufficient funds to fulfil your obligations in case of physical delivery.
How are delivery margins calculated?
The calculation of delivery margins depends on the margin rate applied in the cash market segment for the specific security. Failing to maintain these margins in your trading account when imposed can result in a deficit in your margin balance.
How do delivery margins change over time?
Delivery margins are lowest on Expiry - 4 and gradually increase every day until Expiry Day. They are levied in a staggered manner as follows:
Expiry - 4: 10% of computed delivery margin
Expiry - 3: 25% of computed delivery margin
Expiry - 2: 45% of computed delivery margin
Expiry - 1: 70% of computed delivery margin
Expiry Day - 100% of computed delivery margin
where,
Computed delivery margin = VaR + ELM + Ad hoc margin
- VaR is Value at Risk. It is a risk management measure that calculates a trader's potential loss within a specified confidence level and time horizon.
- ELM is Extreme Loss Margin. It is an additional margin imposed to cover potential losses beyond the calculated VAR. It provides a buffer for extreme market events that may result in higher-than-expected losses.
- Ad hoc margins are temporary measures set by exchanges or brokers in response to unique market conditions or risks not covered by regular margin requirements. They aim to improve risk management during periods of high volatility or uncertainty.
How do increased margin requirements impact traders?
Increased margin requirements can affect you in several ways:
- Reduced leverage - Higher margin requirements mean that you have less leverage. This can limit your ability to take larger positions or execute more trades.
- Increased capital requirements - You may need to allocate more capital to your F&O positions to meet the increased margin requirements. This can reduce the funds available for other trading opportunities.
- Potential margin calls - If your account balance falls below the required margin level, you may face a margin call. This requires you to deposit additional funds or close out your positions.
How can traders manage higher margin requirements?
To effectively manage increased margin requirements, you can consider the following strategies:
- Monitor margin levels - Keep a close eye on your account's margin levels and be prepared to adjust your positions or deposit additional funds if necessary.
- Use stop-loss orders - Implement stop-loss orders to limit potential losses and reduce the likelihood of facing a margin call.
- Diversify your portfolio - Diversify your trading portfolio across different asset classes and instruments to spread risk and reduce the impact of higher margin requirements on any single position.
- Adjust trading strategies - Consider adjusting your trading strategies, such as reducing position sizes or using options strategies with lower margin requirements.
To wrap up
Higher margin requirements for F&O trades close to expiration are essential to risk management in the financial markets. You must understand its reasons and implementing effective strategies to manage increased margin requirements. This way you can continue to participate in F&O trading while minimising the potential impact on your overall trading performance.
Related Articles: F&O Margin Penalty | Using futures as a form of Margin Trading in Stocks | Understanding order types and margining in commodities
