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5 factors that will impact trading due to rise in margins of equity derivatives

Sebi, trading, risk management framework, equity derivatives, Margin Period of Risk , futures & options

Market regulator SEBI has taken several measures to ensure that retail participation in equity derivatives is kept in check. The most recent development being the review of risk management framework for the equity derivatives segment. As per the circular, the Margin Period of Risk (MPOR) for all products in the equity derivatives segment has been set as 2 days. Therefore, the initial and exposure margins shall be scaled up. For initial margins, the revised MPOR shall be given effect by way of scaling up the Price Scan Range (PSR) used for computing the Worst Scenario Loss.

The computation for the Price Scan Range (PSR) has been changed to include Square root (2) instead of 1 for Index & stock futures & options. The aim of PSR is to cover the worst possible movement in the derivative contracts on a single day. The exposure margin percentage computed for index and stock products shall be scaled up by the square root of 2 and shall be 3%*square root (2) for Index Futures and Options and (Higher of) 5% or 1.5 sigma *square root (2) for Stock Futures and Options.

It will impact in the following ways:

1. A higher cost of Trading – Due to an increase in the margin requirements across all equity derivative contracts, traders need to bring in additional capital for the same position, thereby increasing the cost of trading.

2. Reduced Trade volume – Higher margin requirement can lead to a reduction in the FNO volume as the fund requirement increased or less no. of contracts with the same amount of money. Considering that retail trading participation is on the rise, it could have an impact on liquidity for single stock futures as the liquidity is already pretty low.

3. High impact cost – Due to decreased volume in stock futures and options liquidity can worsen and further widens the bid-ask gap or increase the impact cost which leads to increased transaction cost for the traders. This is the least desirable outcome for all the stakeholders involved in trading and investments. It also increases the cost of hedging risk.

4. Reduced level of leveraged positions — SPAN Margin (Standard Portfolio Analysis of Risk) is a system designed to calculate margin requirements for derivative positions all over the world. Increasing margin requirements over and above SPAN is good and ensures an additional cushion against risk and will reduce the level of leveraged position in the system and controls the systematic risk and also reduces the possibilities of the sharp correction in the market.

5. Embedding Risk management culture – The derivative instruments are known for their risky nature and margin plays a crucial role in risk management. Increased margin requirement will help in proper risk management and developing a risk management culture in the market. This is good for all stakeholders, including traders, investors, brokers and the exchanges.

(By Tejas Khoday, CEO and Co-Founder, FYERS)