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Cross-margining: the why and the what

SEBI has announced cross-margining of cash and futures/options, for all participants.

Cross-margining is essentially allowing cash positions (shares in a DP account) to offset margin requirements for hedged futures or options positions. Let’s say you had 75 shares of Reliance, and someone told you that dude, you have lost so much money, why don’t you write covered calls instead?

You ask, “What the hell is a covered call?”

He launches into a long explanation on futures and options and you eventually ask, “This is great, so what do I do?”

A few days ago, he would tell you: “Sell your shares. Then buy a futures contract. Then sell a call option at strike price 1200”.

You’re wondering – why should I sell my shares and buy a future? What’s the point, it’s the same thing: I have a long position on Reliance. If I write a call option, I pocket some premium in exchange for giving someone the right to buy my shares at a certain price. I have the shares. So why bother with a future? And why sell my shares?

The old margining system expected a certain margin per derivative position. A long future position has certain margin, and that can offset the margin required for a short call (a covered call is long future, short call). This meant that if the margin for a long Reliance future position was, say, 40K, I wouldn’t need to add money on it to write a call option on Reliance.

But this margin cancellation doesn’t apply if you held shares. Futures position margins could cancel options positions, but that didn’t work if you held shares in your DP account, instead of the future. The “cross-margining” that is being introduced now, allows you to margin “cash” market positions against “derivatives” positions.

Unfortunately this has not been allowed for options just yet – only for cash versus futures. The above example was just an explanation, but I hope they will consider it for cash vs. options too.

A huge beneficiary is arbitrage. I could buy shares and sell futures, making the resulting arbitrage (typically 1-2% a month, but can be wiped out if you have high transaction costs) cheaper. Earlier you had to pay 100% of the cash value, and around 50% of the future value upfront – so to arb Reliance cash versus Reliance future you had to pay 1.5 times Reliance shares value. Now it’s 1x, because of cross-margining, which will result in better returns on capital and eventually, tighter spreads.

This type of cross-margining was earlier available only to institutions (since May) but now it’s been opened out to all players.

For that purpose though, you have to open two accounts, and exchanges have to issue guidelines to this effect. It might end up taking a few weeks before that happens though.

This is an interesting step, but not good enough – once cash can be offset with options, we’ll see activity perk up in writing calls. SEBI has a lot more to do in terms of addressing the lack of activity in the F&O segment – today, volumes were a dismal 33K cr!

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