Demystifying Derivatives: Margin for options contract and Risk capital in F&O

In our post, Demystifying Derivatives: Margin and risk capital for futures contract, we discussed the margin requirements in futures. We also discussed, how marked to market pricing works, how it affects your margins and your profits and losses in futures contracts. In this post, we will discuss the margin requirement in Options trading. We will also discuss the importance of risk capital in trading and its relationship with your financial planning. Let us first start with margin requirement in Options trading.

Margin in Options Trading

If you are buying options, no margin is required; you simply have to pay the premium (price). The total investment made by you when buying options is the premium times the lot size (Premium X Lot Size of the options contract).

In our post, Demystifying Derivatives: Basics of Futures and Options Part 1, we had discussed that, if the share price is lower than the strike price at expiry, a call option expires worthless (price will be zero); in other words, you lose the premium you paid for the option. If the share price is higher than the strike price at expiry, you make a profit, which will be reflected in the option premium (price). If the option premium (price) at expiry at higher than the purchase price, you will make a profit; else, you will make a loss.

Similarly in the case of a put option, if the share price is higher than the strike price at expiry, the option expires worthless (price will be zero) and you lose the premium you paid for the option. In a put option, if the share price is lower than the strike price at expiry, you make a profit, which will be reflected in the option premium (price). You should know that, margin is required to cover losses. When you are buying options there is no additional risk, other than the premium that you have already paid, there is no margin requirement. You should also know that, like future prices, option premiums are also marked to market. Option premiums depend on the share price and a variety of other factors, like strike price, volatility, time to expiry and interest rates. You need not wait till expiry to book profits or losses in options. You can book profits at any time based on marked to market premium and the premium you paid to buy the option.

While there is no margin requirement if you are buying options, you should know that, if you are selling options (in derivatives parlance, selling options is known as writing options), you will need to put a margin with your broker. When you are writing options, your maximum profit is the premium that you get by selling the option (if the option expires worthless at expiry), but your losses can be unlimited, if share price moves above or below the market price, depending on whether you are writing call or put options. You must be thinking, if profits are limited and losses are unlimited, why will anyone, want to write or sell options.

The reality is that, professional traders write (sell) options more than they buy options. The reason why professional traders like to write options more than buying them is outside the scope of our discussion, but retail investors should know that, writing options is very risky. Anyway, when you are writing options, you will make a profit if the premium decreases and you will make a loss if the premium increase.

You should know that, like futures prices, option premiums are marked to market. In a call option the premium increases when share price increases, premium decreases when share price decreases. In a put option the premium increases when share price decreases, premium decreases when share price increases. As a writer of the option, your profit or loss is the difference of premium at which you sold the option and premium at which you will square off. When you write (sell) an option, the premium amount (premium X lot size) is credit to your trading account (margin). The marked to market profits and losses are also credited / debited to your account on a daily basis.

Like in futures, you have SPAN and exposure margins requirements, when you are selling options. The SPAN margin requirement, if you are selling options, is calculated from the prices of the underlying shares, volatility, the time to expiry and other factors. If you want to write (sell) options, you should check with your broker, what the margin requirements are. Though margin requirements are different in futures and options (sale), the marked to market and margin maintenance is same in futures and options. Like in futures trading, SPAN margins have to be always maintained if you sell options.

Risk Capital

While some of us may a basic understanding of futures and options from text books, understanding how it actually works in the Indian market is of critical importance, if you want to trade in these instruments. In my opinion, whenever you make any investment or trading decision (fixed income, mutual funds, stocks or derivatives) four considerations are of critical importance:-

• Your expectations


• Your risk capacity


• Your investment timeframe


• Your capital

Your investment expectations, risk capacity and investment timeframe should determine which asset category or sub-category you should investment. If you are trading in derivatives, it implies that, your return expectations are very high and your risk capacity is also high. Your investment timeframe at maximum is limited to expiry of the F&O series, unless you rollover your F&O positions (we will discuss rollovers later in this series).

In this post, we discussed margin requirements of F&O and marked to market implications for investors, because it is extremely important for the fourth consideration, your capital planning. Remember, unlike shares or mutual funds, in F&O, you cannot wait indefinitely for prices to rise and give you good returns; F&O contracts expire on the last Thursday of the month. Therefore, it is possible that, you can lose your entire margin amount in F&O. In very bad markets, you can actually lose more than what you have invested.

Your risk capital will depend on your income, expenses, long term investment needs, liabilities, etc. Financial planning is essential, in determining your risk capital. In financial planning, you determine your short term and long term financial goals, your life and health insurance requirements and your contingency planning needs. You need to save and invest on a regular basis to meet those needs. If you have surplus funds after saving for all these important financial objectives, you can consider a portion of that, as your risk capital. Your risk capital should never be at the cost of your important financial objectives, like life and health insurance, retirement planning, children’s education etc. You should budget your investment in F&O margin accordingly.

Some people trade in F&O with capital they cannot afford to lose. These traders usually make terrible mistakes. In the example, where you bought futures contract, you had to make a margin call payment of र 2,300. You were lucky that, the share price increased afterwards, but if the share price fell further, you would have had to make further margin payments and incur a bigger loss, possibly, even bigger than your capital.

In our technical blogs, we have discussed a number of times that, the trend is your friends. However, if you treat your F&O margin, as something you cannot afford to lose, you are likely to make mistakes like price averaging by taking incremental positions. Averaging in F&O is not like SIP in mutual funds, where you can wait for a long time, for prices to recover; F&O contracts have a definite expiry date. Averaging is usually a recipe for disaster in F&O trading in downward trending price environment.

Most brokers allow your stocks in your Depositary Participant (DP) account to be treated as collateral in F&O trading, instead of cash as margin (after applying suitable adjustments, also known as haircut). If the value of your stock portfolio is big, you can take a large position in F&O, but you should ask yourself, whether you can treat your stock portfolio as risk capital? What were the investment objectives when you invested in these stocks? If you bought the stocks with long term capital appreciation objectives, then surely they are not risk capital. You should know that, your broker will not hesitate to sell your stocks at a loss, to meet margin requirements. Therefore, even if you use stocks as collateral in margin, make sure that, your margin is commensurate with your risk capital.

Conclusion

In the last 2 parts of our derivatives series, we discussed the margin requirements of futures and options trading. We also discussed why, from a financial planning perspective, your F&O margin should be treated as risk capital. Knowing what your risk capital is the single most important aspect of F&O trading. In the next part of our derivatives series, we will discuss some techniques used in F&O trading.