How Margin Calculator Helps Traders Manage Risks

In this article, we will discuss

1. What is Margin?
2. What is a margin calculator?
3. How is the Initial margin calculated?
4. What is SPAN margin?
5. What is exposure margin?
6. What is Premium margin and Assignment margin?
7. What is Margin Shortfall Penalty?
8. The benefit of Margin calculator to trader?

Trading in the equity segment involves buying and selling of shares. Shares are exchanged for money. The buyer of shares gives away money to get shares while the seller of shares gives away shares to get money. However, things are a bit different in the derivatives market. In the derivatives market, there is no exchange of shares. It is purely speculation. It’s like taking a bet against each other without any involvement of actual shares. The one who is long on a particular contract expects the price to go up while the one who is short on the same contract expects the price to go down. Since there are no shares or collateral, counterparty risk arises where there is a chance that one party may not fulfil its obligation. Therefore, if anyone wants to trade in the derivatives (Futures & Options) segment, they are required to maintain a certain margin with their stock broker as prescribed by the exchanges. But what is this Margin, how is Margin calculated, and How much margin needs to be maintained? In this article, we will try to address all these questions. We will try to understand all about margins as well as how traders can take the help of a margin calculator to manage their risks.

What is Margin?

Margin is an amount that a trader has to deposit with the stock broker before buying or selling derivatives like Futures & Options (F&O). The margin acts as a security deposit and helps to prevent counter-party risk in case of default. This is similar to the money that needs to be deposited with the landlord before we rent a property, so that in case the tenant defaults in payment, it can be deducted from the deposit amount. Margins are required to be paid by both the Long and short position holders. The margins are different from profit or losses. Margins are fixed by exchanges in order to safeguard stockbrokers when traders experience losses.

What is a margin calculator?

Knowing how much margin is required to be maintained is essential before placing an F&O order. This is done with the help of a margin calculator. A margin calculator is an online tool that calculates the margin required for a particular trade, taking into account several factors such as time, price, and volatility. Higher the volatility, the higher the margins required. Also, the higher the probability of incurring a loss, higher is the margins. As per latest exchange circular, it is mandatory to collect SPAN margin, exposure margin and net buy premium margin at the time of placing a derivative trade by the stock broker.

How is the Initial margin calculated?

Initial margin is the amount that is collected upfront at the time of entering a position in F&O trade. Initial margin is calculated on a portfolio of futures and option positions using a software called - SPAN (Standard Portfolio Analysis of Risk) and exposure margin. Initial margin = SPAN + Exposure margin While the SPAN margin is the minimum amount blocked when entering into an F&O position as per the calculation, exposure margins are money blocked over and above the SPAN margin to cover for any potential ATM (at-the-money) losses.

What is SPAN margin?

SPAN margin is the minimum margin that is required to be collected by the stock broker when traders enter into a derivative contract. This margin is determined by exchanges. The span margin is variable, meaning it fluctuates throughout the day depending upon the volatility in the underlying contract. SPAN is a calculation developed by Chicago Mercantile Exchange (CME) and is used to calculate margins for derivative trades. SPAN uses scenario-based approach to arrive at the adequate margins. It generates about 16 different scenarios and for each of these scenarios, a possible loss that the portfolio would suffer is calculated. The maximum loss that the portfolio would suffer in any of the scenarios considered in one trading day would be the initial margin required to be paid. SPAN calculation logic is not disclosed publicly & it is a tough calculation. SPAN margin is monitored and is revised 6 times in a day. When the volatility in the position increases during the day, the stockbroker would call upon the trader to increase his margin. Similarly, when the volatility decreases the stock broker may release some of the margin blocked earlier. Investors can easily calculate SPAN margin at Samco app or website free of cost.

What is exposure margin?

In addition to the SPAN margin, exposure margin is also collected by the stock broker to cover any additional risks that may arise due to erratic swings in the market or any Black Swan Event. This amount is decided by the stock broker. Unlike SPAN margin, exposure margin does not fluctuate and is fixed at the below rate:

• For index futures and index option sell positions, it is 3% of the notional value.
• For futures on individual stocks and sell positions in options on individual securities, it is higher of 5% or 1.5 standard deviation of the LN returns of the security over the last 6 months on the notional value of position.

What is Premium margin and Assignment margin?

In addition to Initial Margin, a premium margin is also charged when buying an option contract. The premium margin is equal to the value of the options premium multiplied by the quantity of options purchased. Assignment Margin is collected on assignment from the sellers of the contracts.

What is Margin Shortfall Penalty?

According to SEBI Regulations, a margin shortfall penalty is levied if there are insufficient funds in client’s trading account. But since all margins are collected in advance how can a scenario of margin shortfall occur? Let’s take a look at the following example. Let’s assume that at the time of taking a trade the margin required was 1 lakh rupees. The customer had exactly 1 lakh in his account which covered the margin requirement. However, unfortunately the price went against the trader’s position and he incurred a loss of say Rs 10,000 which is known as mark-to-market loss (MToM) loss. Now if the trader does not add this loss of Rs 10,000 to his account, the total value in his account would be 90,000 thus indicating a short fall of Rs 10,000 on which the margin penalty would be charged. In accordance with SEBI’s peak margin framework, the clearing corporation takes snapshots of customer account positions at four random intervals throughout the trading day. If at any time, there is insufficient margin against the position held then an intraday peak margin penalty is levied. Also, when the volatility in the derivative position increases during the trading day, the stockbroker would call upon the trader to increase his margin. If the trader is unable to do so, he will have to sell off his position which could be a loss making move. Therefore, writers of options and futures are required to maintain sufficient margin in their accounts to avoid such instances. On first three instances of margin shortfall in a month, penalty of 1% is levied, post which the penalty increases to 5%.

The benefit of Margin calculator to trader?

Since every trader or investor wishes to maximize his returns on the invested amount, trading on margin or taking leverage helps them to inflate their profits or losses. They can take bigger bets with a smaller capital by paying only the margin amount instead of the full trade value. Also since margins are calculated based upon volatility and the probability of loss for the entire portfolio, the margin requirement falls if the probability of loss goes down due to hedged positions. Hedged positions means taking an opposite position. Thus, margin calculator can be used to calculate the least amount of margin or capital required by taking hedged positions and thereby reducing the risk to the portfolio as well. For eg, a Long Position in Nifty requires a margin of say Rs 1,25,000. The same margin can be reduced by taking a hedged position by say selling a Call Option. Thus both positions are opposite to each other in nature & reduce the margin requirement as the risk has reduced. Thus a trader can use a margin calculator to tray and create various combination of position where the margin required and thus the risk is lowest and generate a higher return on the capital employed.

Conclusion

The margin calculator helps the trader to know the margin that they need to maintain with the stock broker. This also helps them to avoid margin shortfall penalties and save them any additional cost associated with a trade. Margin also helps the investor understand the risk associated with the trade. The margins go up when the volatility in the stock price increases, this in itself is a warning bell to the trader to not overindulge and play with caution. Samco provides various investment options to help you meet your financial objectives. To learn more about its offerings visit Samco’s website. To begin your investing journey, open a demat account with Samco for free. Trade and invest online at flat fees of Rs.20/order in stocks, futures, options, currency, commodity, mutual funds & basket of stocks with Samco account