The National Stock Exchange introduced futures and options contracts in the year 2000. Since then, the trading volumes in futures and options contracts have increased substantially.
When trading in futures and options (F&O), stockbrokers ask you to fund your trading account with certain margins before allowing you to initiate a trade. You must pay these margins, whether you are buying or selling F&O contracts. F&O margins are collected to cover the risk of any adverse volatility in the prices. Let’s understand this in detail.
Why Do Brokers Collect F&O Margins?
When you purchase options contracts, the risk amount is limited to the premium paid. However, when you trade in futures contracts or sell options, the risk can be unlimited. Hence, brokers collect margins from traders to reduce the risk of any default by traders.
When F&O contracts were introduced by the SEBI, it also introduced a framework for the collection of F&O margins from anyone participating in these contracts. The margin that is required to be paid upfront for entering contracts with unlimited risk is called the initial margin, which is the sum of SPAN and exposure margins.
Types Of F&O Margins
Some of the F&O margins charged by brokers are:
SPAN margin SPAN stands for Standardised Portfolio Analysis of risk. This margin is based on the concept of value at risk. The SPAN margin is calculated in a way that the margin is large enough to cover the maximum potential loss from the trade in a single day. Hence, if the underlying asset has a greater risk due to extreme volatility, the F&O contracts on the asset will have a higher SPAN margin.
Exposure margin The margins are levied over and above the SPAN margin. Exposure margins are used to cover the risks that SPAN margins may not cover. In India, the exposure margin for index futures and options is set to 3%, and that for stock F&O contracts is set at 5%.
MTM margin MTM or mark-to-market margin is collected by brokers to cover the daily volatility in the price of the F&O contracts. If the underlying security of your contract keeps moving against you i.e., if the price of the security keeps falling when you are long or if it keeps rising when you are short, then the broker will collect MTM on each subsequent day to cover the loss.
How Is F&O Margin Calculated?
Here’s what the F&O margin calculators consider to derive the F&O margins:
For buying options contracts: The option premium + other delivery margins that may be charged before the physical settlement
For selling options contracts and for futures contracts: SPAN + exposure margin + other delivery margins that may be charged before the physical settlement + any other margins levied by the exchange
To cover any additional risk, the broker may also charge an additional margin that may be over and above the margins levied by the stock exchange.
In Conclusion
Now that you have understood the meaning of futures and options margins, you now know that it is essentially a risk management measure. The securities markets are volatile by nature, and trading in futures and options is risky as the price movement of the underlying assets can go against you. Hence, brokers collect the futures and options margins to cover the risk of this volatility.
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