New margin framework
As of 1st June 2020, the margin requirement for a hedged position has been lowered with NSE’s new margin framework going live.
You may be wondering what a hedged position is. We have covered this issue several times in this module, so here is a quick recap.
Without a helmet, riding a bike at 75 Kms per hour, you encounter a pothole and hit the brakes to reduce speed. Unfortunately, it’s not quick enough and you crash. As expected, the probability of head injury is high due to the lack of protection.
Visualise the same circumstances, but with a helmet this time. What is the chance of injuring your head in such a situation? Most likely not much, since we have the safety guard to thank for that.
The helmet acts as a hedge against a potential disaster.
Having a naked futures or options position in the market is similar to riding a bike without wearing a helmet. There is an elevated risk that the market could move against your position, resulting in capital loss.
However, if you hedge your position, then the risk of losing capital reduces drastically.
Think about this – if your capital loss is minimal, then the risk for your broker and exchange decreases as well.
So what does this mean to you as a trader?
Keep in mind that the margin requirements are dependent on the level of risk you are willing to take – low risk will mean a lower requirement and more risk will necessitate a higher requirement.
Therefore, this means whenever you initiate a hedged strategy, the margins blocked by your broker are less compared to the margin required for a naked position.
In essence, NSE has proposed the same in the new margin framework.
You can check this presentation by NSE for more details.
The presentation is quite technical, but you don’t need to strain yourself trying to comprehend it unless you really have the urge.
From the perspective of a trader, there are three primary points to take away from the new margin policy. These have been summarised in a single slide, which is included here.
Starting from the top –
What does this mean to you as an options trader?
Some strategies which looked good on paper, but had too large of a margin requirement to be feasible, now appear appealing.
Can you tell me why the margin required is larger when taking a spread position instead of a neutral stance in trading?
Take the time to ponder this and submit your opinion in the comment area.
Given this, I want to talk about one more options strategy in this module, which I had not brought up previously due to its high margin requirement. However, it is no longer the case.
– Iron Condor
The iron condor is an inventive four-legged option strategy that is a variation of the short strangle.
I’ve captured this image from the Strategy Builder of Sensibull. It can be observed that Nifty is currently at 9972.9 and I’m attempting to execute a short strangle by selling out-of-the money calls and puts.
Since both the options are written/sold, I get to collect a total premium of 164.25+145.25 = 309.5.
Many traders are fond of this method due to the fact it permits them to hang on to the premium so long as Nifty remains within its usual range. Furthermore, this is an ideal approach if you want to benefit from volatility; if you suspect a market event may trigger volatility and lead to higher option premiums, then you’d be wise to become an options seller and capitalise off the subsequent high premiums. In such a case, short strangles is the most suitable option.
In a short strangle, since you sell/write options, it results in a net premium credit. In this case, you get a premium of Rs.23,288/-.
A potential downside to using short strangles is the vulnerability of the open ends, which can lead to losses if there is a shift in the underlying asset’s price.
For example, this particular short strangle has a range of safety between 9490 and 10411.
There was a COVID-19 crash in early 2020 followed by quick recovery from the lows.
If a sudden shift occurs in the market, you could lose your entire portfolio. The unlimited potential of loss causes both you and your broker to operate at a heightened risk level, thus resulting in high margin rates.
The cost to establish a short strangle is quite substantial at almost 1.45L, making it unfeasible for most traders.
Although it’s not necessary to abandon the short strangle, I’d recommend setting up an iron condor instead. It’s a far superior strategy in my view.
An iron condor improvises a short strangle by plugging in the open ends. Think of an iron condor in 3 parts –
This makes an iron condor a four-leg option strategy. Let us see how this looks –
The short option premium can pay for the long option positions, if you take this into consideration.
By purchasing two protective options, you reduce the potential for profit to some degree.
As evidenced, you can now make a maximum profit of Rs.9,634/- with less pressure.
The maximum risk has been capped at Rs.5,366, giving me greater clarity on potential losses and avoiding open-ended exposure. This is an excellent development in my opinion.
The amount of profit one could make is limited, as long as Nifty remains between 9672 and 10228. Visibly, the range here is narrower than it was in the short strangle.
Considering the risk, what does this imply for you as a trader and the broker? You have a complete understanding of the potential for loss. It’s easy to see the most negative outcome.
You got it! Now that the risk has been defined, the margins are reduced.
NSE’s new margin framework works wonders here; the upfront margin for an iron condor is just Rs.44,303/-, significantly lower than the short strangle’s Rs.1.45L requirement.
Previously, retail traders found it difficult to execute an iron condor because of the high margin required. These margins and premiums were estimated in the region of 2 – 2.2L.