Low margin to keep F&O mkt volatile (The Economic Times 25th Jan 2008)
What are margins in the equity derivatives segment? Margins are the funds that must be deposited with a clearing exchange, through a broker, for an investor to trade (or keep an open position alive) in the futures and options (F&O) segment. There are two types of margins: initial margin and mark-to-market (MTM) margin. Initial margin is the first payment that’s required to be paid out to open a futures contract. This margin is relevant to investors involved in the futures segment and options writers (sellers). Simply put, margin is the price of one lot size of futures contracts or for option writing. The initial margin, which is a percentage of the contract value, is specified by the exchange daily, subject to a minimum amount. For instance, if Infosys trades at Rs 1,000, one lot size of its futures contract is 200 units and initial margin is 20%, then the an investor has to pay Rs 40,000 (20% of 1,000 x 20) as initial margin.
Options writers also are required to pay these margins, as they are at the risk of unlimited losses, when they sell options, in exchange of a premium amount. MTM margins is the amount an investor needs to pay on a daily basis, in case he incurs losses on his positions. So, if he buys 1 lot size of Infosys futures, expecting that the stock will move up to Rs 1,200, but instead it slips to Rs 800, the exchange asks for additional margins for the losses. The broker is responsible for collecting MTM margins from the clients. How are margins calculated? The SPAN (Standard Portfolio Analysis of Risk) system is used by stock exchanges across the world, including India, in margin calculations and risk management. The SPAN margin, also known as initial margin, is structured to cover 99% of the likely losses of an individual on a single trading day, using 16 possible scenarios of change in prices. The SPAN system basis its calculations on the expected volatility (deviation from the mean) in the prices of contracts. So, if the volatility shoots up—when the market either gains or falls sharply—the required initial margins also rise accordingly, because the margins are a function of volatility. How can volatility & initial margins be related? The key link to hypothetical relationship between volatility and initial margin requirements is leverage (borrowed money). The popularity of the F&O segment is the ability to leverage (which can be seen in the Infosys example above). When initial margins are low, it encourages investors to trade more in the F&O segment, which results in spike in prices, even above the real value of these shares. Such rise beyond fundamentals may trigger some uncertainty, leading to higher volatility. When volatility jumps and results in a corresponding rise in margins, investors are constrained by the higher margin requirements. Higher margin needs reduces the incentive for investors to take leveraged bets. So, margins requirements can be altered, as and when there sharp rise in volatility. In India, when markets are stable, initial margins usually are in the 7.5% (minimum required) to 20% range. But, when volatility jumps, these margins rise up to 50-75%. On Wednesday, margins for select stocks in the F&O segment were believed to have risen sharply. How can an one fulfil margin requirements? Cash is most widely accepted form to meet margin requirements. Brokers also accept debt instruments and some liquid shares as collateral for meeting up to 50% of the margin requirements. FIIs have been allowed to provide AAA-rated foreign government securities as collateral for margins against transactions in the derivatives segment. What happens when investors do not pay up the mark-to-market margins? The MTM margins keep changing daily, as per the movement in the market. So, if an investor bought Infosys futures and the price fell, he has to pay up for the losses. The broker makes a call for additional margins. If the client is unable to pay the additional margin amount, the broker squares off the positions. Brokers could also face losses, if investors do not pay up the MTM margins, in turn, putting the settlement system at risk.
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What are margins in the equity derivatives segment? Margins are the funds that must be deposited with a clearing exchange, through a broker, for an investor to trade (or keep an open position alive) in the futures and options (F&O) segment. There are two types of margins: initial margin and mark-to-market (MTM) margin. Initial margin is the first payment that’s required to be paid out to open a futures contract. This margin is relevant to investors involved in the futures segment and options writers (sellers). Simply put, margin is the price of one lot size of futures contracts or for option writing. The initial margin, which is a percentage of the contract value, is specified by the exchange daily, subject to a minimum amount. For instance, if Infosys trades at Rs 1,000, one lot size of its futures contract is 200 units and initial margin is 20%, then the an investor has to pay Rs 40,000 (20% of 1,000 x 20) as initial margin.
Options writers also are required to pay these margins, as they are at the risk of unlimited losses, when they sell options, in exchange of a premium amount. MTM margins is the amount an investor needs to pay on a daily basis, in case he incurs losses on his positions. So, if he buys 1 lot size of Infosys futures, expecting that the stock will move up to Rs 1,200, but instead it slips to Rs 800, the exchange asks for additional margins for the losses. The broker is responsible for collecting MTM margins from the clients. How are margins calculated? The SPAN (Standard Portfolio Analysis of Risk) system is used by stock exchanges across the world, including India, in margin calculations and risk management. The SPAN margin, also known as initial margin, is structured to cover 99% of the likely losses of an individual on a single trading day, using 16 possible scenarios of change in prices. The SPAN system basis its calculations on the expected volatility (deviation from the mean) in the prices of contracts. So, if the volatility shoots up—when the market either gains or falls sharply—the required initial margins also rise accordingly, because the margins are a function of volatility. How can volatility & initial margins be related? The key link to hypothetical relationship between volatility and initial margin requirements is leverage (borrowed money). The popularity of the F&O segment is the ability to leverage (which can be seen in the Infosys example above). When initial margins are low, it encourages investors to trade more in the F&O segment, which results in spike in prices, even above the real value of these shares. Such rise beyond fundamentals may trigger some uncertainty, leading to higher volatility. When volatility jumps and results in a corresponding rise in margins, investors are constrained by the higher margin requirements. Higher margin needs reduces the incentive for investors to take leveraged bets. So, margins requirements can be altered, as and when there sharp rise in volatility. In India, when markets are stable, initial margins usually are in the 7.5% (minimum required) to 20% range. But, when volatility jumps, these margins rise up to 50-75%. On Wednesday, margins for select stocks in the F&O segment were believed to have risen sharply. How can an one fulfil margin requirements? Cash is most widely accepted form to meet margin requirements. Brokers also accept debt instruments and some liquid shares as collateral for meeting up to 50% of the margin requirements. FIIs have been allowed to provide AAA-rated foreign government securities as collateral for margins against transactions in the derivatives segment. What happens when investors do not pay up the mark-to-market margins? The MTM margins keep changing daily, as per the movement in the market. So, if an investor bought Infosys futures and the price fell, he has to pay up for the losses. The broker makes a call for additional margins. If the client is unable to pay the additional margin amount, the broker squares off the positions. Brokers could also face losses, if investors do not pay up the MTM margins, in turn, putting the settlement system at risk.
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