Introduction

• 'Hedging' is a risk management strategy that reduces the potential loss that occurs from an existing position.
• You are required to pay a margin if you enter into a futures and options (F&O) contract. The margin amount is different for every hedge contract.
• This amount is calculated based on the volatility of the underlying stock or asset, and that's where F&O margin calculators gain significance.
• You must deposit the initial margin to initiate a hedge contract, no matter the amount.

What is the Approach to Calculating the Margin?

• In F&O contracts, there are two types of margins, with various other sub-types. These are 'initial margin' and 'exposure margin'.
• Regular traders are likely to be familiar with Standard Portfolio Analysis of Risk (SPAN), the software used to calculate the initial margin for F&O positions.
• SPAN takes the maximum potential loss of the underlying asset into account when calculating the margin.
• If the underlying asset possesses higher risk due to its volatile nature, its SPAN margin will consequently be higher.

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In a normal margin calculation, the initial margin is generally 10-15% of the contract's notional value. Variations in the margin of the futures position happen due to the volatility and risk level of the stock. This is higher in the case of intraday margins, where the initial margin for index futures is 40% of the normal margin, and 50% for stock futures.

How is Margin Calculated in India?

• This approach is followed in F&O contracts in India as well. The initial margin requirement is 99% of the value of the risk over the period of a day.
• The mark-to-market settlement value of an index or stock futures contract may not be known until the next day’s trading. Therefore, the initial margin is calculated over a two-day period.
• The value-at-risk percentage is computed as per the SEBI recommendation applicable to the period.
• If you are shorting options or executing futures contracts, you need to deposit the full margin before entering a call position.
• On the other hand, if you buy a call option before buying a short option or a futures contract, the hedge position can be executed with the least margin.

What is the Peak Margin Requirement?

• To foil intraday trading risks, SEBI allows brokers to collect the full margin.
• For this purpose, the exchanges have a margin deposit requirement in place to ensure that traders have the required funds to carry out the trade. Collecting the entire margin further increases transparency in F&O transactions.
• The introduction of peak margin by SEBI was done in a phased manner, with a 100% margin becoming applicable in the fourth phase of implementation.
• Exchanges and clearing corporations take four snapshots of the trading position to calculate the margin requirement. The highest of the four snapshots is used to decide the peak margin of the day.
• The minimum margin requirement for the four snapshots is calculated, and the highest of the four becomes the peak margin.
• Since September 2021, a 100% margin has been deposited by the trader with the broker upfront while placing the order.

What is the Effect of the  Peak Margin Requirement?

• Due to the entire margin requirement, traders must now deposit the entire margin upfront.
• A balance equal to or greater than the peak margin must be maintained in the trading account while placing a hedge order. Unlike earlier, traders are not in a position where they end up paying margin shortfall penalties.
• Since August 2022, the margin requirement for a particular trading session has been calculated at the start of the day.
• Subsequent changes in margin requirements don’t lead to a margin shortfall, and hence, no margin shortfall penalty is applicable.

Conclusion

• To summarise, depositing the full margin instead of a lower amount indicates that your initial investment in the trade is higher.
• This also shows that the return on investment could be lower. However, it reduces your intraday trading risk as well.

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