You are a trader excited about entering the stock market with high hopes of making profits. One day, you come across a margin call, leaving you confused and worried about your trading position. If you have ever wondered why brokers ask for additional funds when trading derivatives, it’s because of margin requirements. In particular, the two critical margins you need to know are SPAN margin and Exposure margin. These margins safeguard traders and the stock exchange from potential market volatility. Knowing how these margins work can make a huge difference in managing your trades effectively if you are serious about trading.
What is Margin Trading?
Margin trading is a financial approach in which investors borrow capital from a broker to trade securities, using their current investments as collateral. This strategy enables them to acquire more securities than their available cash would allow, enhancing potential returns but also raising the risk of losses.
You open a margin account with your broker when you engage in margin trading. Unlike a regular brokerage account, this account enables you to borrow funds to purchase more securities. The borrowing limit is set by the margin requirement, which indicates the proportion of the purchase price that your own funds must cover. For example, if the market margin requirement is 50%, you can borrow up to 50% of the total purchase price of the securities.
To illustrate this, let’s take an example. Suppose you wish to buy stocks on a margin worth ₹1,00,000, but you only have ₹50,000. You can borrow the remaining ₹50,000 from your broker with a margin trading facility (MTF). If the shares rise in value to ₹1,20,000, you can sell them, pay off the ₹50,000 loan, and keep the ₹20,000 profit (after considering any interest and fees). However, if the value falls to ₹80,000, you will still owe your broker ₹50,000, resulting in a significant loss.
What is SPAN?
SPAN (Standard Portfolio Analysis of Risk) Margin assesses the total risk of a trader’s portfolio and estimates possible losses that might arise in a single trading day. This system uses algorithms considering various parameters, such as the asset’s price and volatility, the time until expiration, and the risk-free interest rate. Its primary goal is to guarantee that traders maintain enough margin to cover potential losses and keep up with market stability and integrity.
How Does SPAN Work in Different Scenarios?
Here is how SPAN in different margin trade works:
Example 1: Nifty Futures Contract
Suppose you are a trader with a long position in one Nifty futures contract. If the contract value is ₹25,00,000 and the SPAN trading margin requirement is set at 10% of the contract value, your calculation would look like this:
(SPAN Margin) = (Contract Value) х (SPAN Margin Percentage)
= ₹25,00,000 х 0.10
= ₹2,50,000
In this case, you must maintain a margin of ₹2,50,000 for this position.
Scenario 2: Bank Nifty Call Options
Suppose you are selling Bank Nifty call options with a strike price of ₹35,000 and a premium of ₹500. If the SPAN margin requirement is 15% of the notional value of the contract, you would calculate it as follows:
(Notional Value) = (Strike Price) х (Lot Size)
Assuming the lot size is 25:
Notional Value = ₹35,000 х 25 = ₹8,75,000
SPAN Margin = (Notional Value) х 0.15
= ₹8,75,000 х 0.15
= ₹1,31,250
Here, you are required to maintain a margin of ₹1,31,250.
Scenario 3: Multi-Leg Options Strategy
You are a trader using a bull call spread strategy. You buy a call option through an investment app with a strike price of ₹10,000 and sell a call option with a strike price of ₹10,500. If the SPAN margin requirement for the bought call is ₹20,000 and for the sold call is ₹25,000, your net margin requirement would be:
Net SPAN Margin = {SPAN Margin (Bought Call)} + {SPAN Margin (Sold Call)}
= ₹20,000 + ₹25,000
= ₹45,000
Here, you are required to maintain a margin of ₹45,000 for this strategy.
What is the Exposure Margin?
The exposure margin is calculated by assessing a trader’s total exposure to market risks. It considers the volatility and interrelationships of the various financial instruments in the portfolio. For example, a portfolio with many volatile stocks will require a higher exposure margin than one with stable assets.
Calculation of Exposure Margin in Different Scenarios
The Exposure Margin calculation varies by financial instrument and trading scenario. Here are some common examples:
Scenario 1: Index Futures and Options:
Regarding index futures and options, the Exposure Margin is typically figured as a percentage of the contract value. For example, it could be set at 2% of the contract’s value (Spot price multiplied by Lot size). This means that if the contract value stands at ₹10,00,000, the Exposure Margin would be ₹20,000.
Scenario 2: Stock Futures and Options
With stock futures and options, the exposure margin tends to be higher due to the increased volatility of individual stocks. It is commonly calculated as 3.5% of the contract value or 1.5 standard deviations of the logarithmic returns for the underlying stock over the preceding six months. For example, with a contract value of ₹5,00,000 and a risk assessment of 3.5%, the exposure margin would amount to ₹17,500.
Scenario 3: Intraday Trading
In intraday trading, the exposure margin is determined by the trade’s overall value and the nature of the security being traded. Generally, the margin requirement for stocks with high volatility tends to be higher than those more stable. For instance, if you are trading a high-volatility stock through MTF app worth ₹2,00,000, the exposure margin could be set at 5%, resulting in a margin of ₹10,000.
Scenario 4: Delivery Trades
In delivery trades, where securities are retained overnight or longer, the exposure margin is calculated to mitigate potential overnight risks. Typically, this margin is higher than that for intraday trades due to the increased risk associated with holding positions over a longer duration. For instance, if you have a stock worth ₹3,00,000, the exposure margin might be established at 4%, leading to a required margin of ₹12,000.
What is a Margin Call?
A margin call occurs when the value of your margin account declines to a point where it no longer meets the broker’s minimum equity requirement. This results in a request for additional funds or securities to restore the required balance.
If you receive a margin call, you will need to either add more money or marginable securities to your account. Alternatively, you can sell off some of your investments to make up the difference. Timely action is important to prevent the broker from liquidating your assets.
Let’s say you bought shares worth ₹1,00,000 using ₹50,000 of your own money and ₹50,000 borrowed from your broker. If the shares drop in value to ₹70,000, your equity would fall to ₹20,000 (₹70,000 – ₹50,000). If your broker’s maintenance margin is 25%, you need at least ₹17,500 in equity (25% of ₹70,000), which you still have with ₹20,000. But if the shares fall to ₹60,000, your equity becomes ₹10,000, falling short of the required ₹15,000 (25% of ₹60,000), resulting in a margin call to either add funds or sell shares.
Conclusion
Understanding SPAN and Exposure Margins is crucial for every trader involved in derivatives. These margins act as protective buffers against potential market risks and ensure market stability. By grasping how SPAN evaluates portfolio risks and how Exposure Margin considers market volatility, you can better manage your trades and prevent unwanted surprises, like margin calls. Staying informed and prepared with the right margin strategies will significantly improve your chances of success in the stock market.
To start trading on margins in the derivatives market, you need to first open a Demat Account Online with a broker like HDFC SKY.
