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Futures & Options

Marginal pressure

A lot of brokers have recently complained, in print and on mainstream TV, that NSE arbitrarily adjusts its margins upwards when a crash happens, and that triggers defaults at brokers, and for the traders who keep only the exact amount of margins required. This is largely in the futures bazaar – cash market trades needs to be fully paid up on the next day of the trade (or squared off).

First, a digression into margins. A futures contract is usually about 2-3 lakhs in value, but since the transaction is in the future, the exchange does not require the full value upfront. They ask for a certain percentage of the contract, typically 10%-20%. So a Nifty future contract – 50 lot size x 6000 value say, is about 300,000 in value, for which the exchange asks for a margin of around 33,000.

This percentage, of course, varies based on certain parameters. Futures are marked-to-market every day – so if you bought a futures contract at 6000, and the Nifty went up to 6200, you would get the 200 (multiplied by the lot size, 50 per contract) in your cash balance every day. And the margin would now be a percentage of 6200.

The reason why margins are required is to cover volatility. The rough belief is that within a day there won’t be more than 10% move on indices and 20% on stocks, so that much margin should be enough to cover a day’s move. So, if volatility goes up (from the average 1-2% a day move, to say average 4-5% moves) the NSE should demand higher margins, no?

They have institutionalised this by using SPAN, a method used by the Chicago Options Exchange. SPAN uses volatility measures to find out how much of a contract value is at risk, therefore how much margins you can place. All brokers are required to download SPAN files from the exchange every evening, around 7:30pm, to determine how much margin is payable to the exchange for their and their clients’ positions.

On the fateful Monday and Tuesday, the index had fallen around 25%. This kind of volatility triggered a big increase in the span margins, the mark-to-markets notwithstanding. For example, let us say you had a single Nifty futures contract (long) open at 6200 prior to Monday. THe margin you required was, say, 11% – meaning 11% of (6200×50) which is around Rs. 34,000. On Tuesday evening the Nifty was around 4600, a loss of 1600 points to you on mark-to-market, which translates to Rs. 80,000 in losses.

Secondly you still have the position, but since volatility has gone up remarkably, the SPAN margin goes up to say 20%. That means you need Rs. 46,000 as margin to keep the same position.

From a 34,000 investment, you’ve now got to pay the broker 80K for your losses, and another 12K for the additional margin, a net outgo of 92K per lot. And most traders deal with more than 10 lots; and a 10 lot trader would probably keep around 8-10 lakhs as capital (that’s pushing it – most traders live on the edge, using up nearly all of their capital in margins, so some of them have only 4 lakhs capital for 10 lots). With this move they’ve lost about 8 lakhs in losses, and need to put in an additional 1.2 lakhs in margins – cash they just do not have!

So they default, and in turn, their brokers default to the exchange which immediately switches off their access. And now the remaining clients of the brokers can’t even trade even if they have money in their accounts! A complete mess, and who is being blamed? The NSE, with brokers saying their margin requirements screwed it up.

It wasn’t the NSE. It was overtrading by the individuals and the fact that brokers did not ask for additional margin upfront on Monday (brokers have a right to ask for more margin whenever they like). The exchange just followed an automated system, it was the individuals stupidity to overtrade in the first place. I don’t think we should blame the exchange for this – all leverage comes with the potential of big losses.

The one thing that could have been done better was to NOT switch off broker terminals by the exchange. There could be a facility for “only square off” which means no fresh positions, but only squaring off of existing positions will be allowed until margins are stabilised. Switching off terminals is such a stupid thing to do – because you can’t even cut your losses! We are in a much better technology zone and the NSE folks can easily do this. Considering the volatility has caused at least two circuits and stop-trading zones in the last six months, they should have done this already! [I have no idea if they already have, please let me know if you do]

Note: If you’re dealing with futures, please keep at least Rs. 1 lakh per contract as potential margin requirements or an additional 10% move in the underlying. So for a Nifty contract, the margin is now Rs. 50,000, but keep another 50K in reserve for a 10% move against you. And square off those losses when they happen; this time no one can complain about not having time – Monday was a slow and steady downward move.