Mark to Market (MTM) and Profit/Loss Calculation

Margin and M2M

The structure of a futures contract eliminates counterparty/default risk. Instead, there is price risk to be aware of; exchanges aid in mitigating this by blocking margin when buyers and sellers enter into the trade, as well as running a daily mark to market process.

Margins ensure a stake in the endeavour, whilst the mark to market process ensures profits and losses accrued daily are appropriately credited/debited.

Having explained the technicalities of margins and mark to market in the futures module, I want to switch our focus back to options. Please keep these concepts in mind.

Options Buyer

Visualise yourself as an options buyer. The cost of buying such options will be the rate of the premium multiplied by the lot size and the number of lots. All together, it will add up to the total amount which needs to be paid.

For example, if I want to buy one lot of Tata Motors 950 Call option:

The call option is trading at Rs 42, lot size is 1,500, therefore:

1 × 1,500 × 42

= Rs 63,000

As long as I have Rs 63,000 sitting in my account, I can purchase the Tata Motors 950 CE. Essentially, this is a cash and carry agreement, thus making it discernible that two facts are certain:

To purchase an option and enter into an agreement, one must have Rs 63,000

The maximum risk for the buyer—again Rs 63,000

When you purchase either a call or put option, the risk is already established and does not continue indefinitely like with the purchase of futures. Additionally, it’s a cash transaction so there won’t be any worries of defaulting on payments.

Given that the risk of default is zero, it is illogical to block margins for an option buyer; this should be clear.

Do we need to tally up the daily profits and losses for the option buyer? We will answer that soon.

Consider the position of the person selling the option.

An option seller’s risk is much higher than an option buyer’s. It is comparable to that of a futures trader.

The risk of option selling is open-ended, and that introduces the risk of default as well.

Much like futures, options selling also carries a certain amount of default risk. Therefore, the exchange requires option sellers to pay a margin (SPAN + Exposure) to ensure that they are covered in the event of a loss.

For example, if I were to sell the Tata Motors 950 CE, the margin I need to bring to the table is Rs 2,15,800.

In contrast to a futures contract, no mark to market is necessary in options. This is because, when entering into a trade, only the seller must deposit margin, whilst the buyer fully pays the premium upfront.

A mark to market in options implies that notional gains or losses need to be credited or debited to the purchaser of the option, without any margins being placed on the exchange.

Hence there is no concept of mark to market (M2M) in options.

The lack of a mark to market raises a commonplace question: how are profits and losses determined for options?

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding options margin requirements and profit/loss calculation proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending why options don’t require M2M settlement and how margins differ between buyers and sellers enables better capital management and clearer understanding of risk profiles in options trading.

Options P&L for the Buyer

Option P&L is relatively straightforward, and the absence of mark to market makes it simpler to comprehend when compared to grasping the Profit and Loss of futures.

The complexity of comprehending P&L implications arises from the various market situations related to the position at hand. To be more precise:

A trader has the choice to take a long or short position on a call option, with the potential profit and loss changing depending on whether they hold it up until expiry or close it earlier.

The same goes with the put option:

To be successful as an options trader, you must be able to accurately calculate the gain or loss in each situation.

Fortunately, we can use the same P&L for both long and short trades when we close before expiry.

At expiry, physical settlement comes into play, making it a bit complex to grasp.

Call and Put Option Long, Close Before the Expiry

The trader’s P&L can be estimated if they choose to close their position prior to the expiration date. This will hold true for both calls and puts traders.

P&L = [Difference between buying and selling price of premium] × Lot size × Number of lots

If I purchase two lots of HDFC Bank 1,650 CE at Rs 85 and then, a few hours later, sell them at Rs 92, I have realised a profit:

= [92 – 85] × 550 × 2

= 7 × 550 × 2

= 7,700

Of course, Rs 7,700 minus all the applicable charges.

The P&L calculation is the same for long put options, squared off before expiry.

Call and Put Option Short, Close Before the Expiry

When a trader shorts an option, margins are blocked in accordance with SPAN and Exposure.

Margin charged is a function of premium price and the volatility of the underlying. Generally, margin increases if:

The price of the option (premium) moves against your position

Volatility increase

Both don’t need to happen; margins can increase even if one of them occurs.

Let’s take the example of the HDFC Bank 1,650 put option, with a lot size of 550. Writing this option means that, despite volatility remaining unchanged, the cost of premium rises to Rs 145, resulting in an extra of Rs 60 per unit and therefore a margin hike of Rs 33,000 (60 × 550).

When you write the option, volatility increases and the price stays constant. Moreover, margins go up. As discussed in the chapter about volatility, this usually leads to an increase in option premium.

Have a look at this again:

In order to embark on a covered call writing strategy with HDFC Bank 1,650 CE at Rs 85 per lot, a margin of Rs 1,85,250 needs to be invested. If the price subsequently escalates to Rs 145, then the required margin will become substantially greater:

60 × 550

= 33,000

Therefore, the new margin required is:

= 185,250 + 33,000

= 218,250

The broker will now alert parties to bring in extra margins (margin call) since the margin utilisation rate is at:

Current margin / Margin at the time of writing the option

= 218,250 / 185,250

= 118%

If you do not manage to bring in the extra margins, the agent can close your short position due to the fines put in place by the peak margin policy. Generally speaking, 120% is the limit for margin utilisation, and if it goes beyond this limit, your broker will instantly close your position.

Continuing on with our example, as soon as the premium hits Rs 145 and you no longer want to keep your position (by putting more money into your account), you can decide to close it.

The P&L is:

[Difference between the buy price and sell price of premium] × lot size × number of lots

= 60 × 550 × 1

= 33,000

Once the position is squared off, the margin will be released after taking account of any gain or loss. If you need to make a withdrawal, your profit and loss will be settled on a T+1 basis.

Now let’s shift focus to options trades held to expiry.

Call Option, Long, Held to Expiry

Options held to expiry that are In the Money (ITM) will be physically settled. However, if the option is Out of the Money (OTM), then the buyer forfeits their premium and the seller retains it.

In this chapter, we have examined physical settlement in detail; for the sake of providing a thorough overview, let us now quickly discuss only the P&L element.

Figuring out the P&L for a long call position until it matures can be a little complicated, since the equity options are physically settled.

Continuing with the example, assuming HDFC Bank settles at Rs 1,780 on expiry, the 1,650 call option is In the money (ITM), meaning it must be physically settled. This gives the option buyer the right to purchase HDFC Bank at the strike price of Rs 1,650 and they have paid a premium of Rs 85 in doing so.

The effective price at which you get the shares is strike price + premium paid. In this case:

1,650 + 85

= 1,735

Assuming the equity price on Monday is Rs 1,780, the profit you’ll make here is:

1,780 – 1,735

= 45

As you are aware, derivatives expire on the last Thursday of every month and shares are then delivered two business days later, typically falling on the Monday.

Call Option Short, Held to Expiry

The option seller, in this instance, dispenses their 1,650 CE at Rs 85 and must supply the relevant amount of shares. However, they benefit from a premium of Rs 85, thereby reducing the effective price:

1,650 + 85

= 1,735

The equity is trading at Rs 1,780, but the seller sells the same at Rs 1,735. The loss for the option writer is:

1,780 – 1,735

= 45

The shares will be debited from the seller’s Demat account and credited to the buyer’s Demat account.

Put Option, Long, Held to Expiry

Let us change the example from HDFC Bank to Wipro, to break the monotony.

Here are the trade details:

Underlying = Wipro

Strike = 450

Premium = 18

Option type = Put

Position = long

Settlement price = 420

Since the settlement price is Rs 420, Rs 450 is an ‘In the Money’ (ITM) option that requires a physical delivery. Therefore, the buyer of a put option will have the right to either sell it or hand over the underlying asset.

The put option buyer will pay a premium and deliver shares at Rs 450. The effective cost of that delivery is thus, higher:

Strike – Premium

= 450 – 18

= 432

The put seller gets to sell the equity at Rs 432 when the same equity is trading at Rs 420. The gain here is:

432 – 420

= 12

Put Option Short, Held to Expiry

The put option seller has to accept delivery of the shares at the settlement price, in this case Rs 420. However, they have been rewarded with a premium which brings down the effective cost of taking delivery to:

Strike – premium

= 450 – 18

= 432

The put option seller has to accept delivery of the shares at a cost of Rs 432, whereas the market rate for the underlying is Rs 420—resulting in a loss of Rs 12.

Of course, if you have two ITM options in opposite positions, physical settlement of these options is net off. An example of this could be a spread position; one option with a ‘give delivery’ obligation and another option with a ‘take delivery’ obligation. I recommend reading this chapter to gain better understanding of position offsets.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding options P&L calculation across different scenarios proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending how profits and losses are calculated for positions closed before expiry versus those held to physical settlement enables better expectation setting and more informed decision-making about when to exit options positions.