SEBI’s margin rules stressing you out? Here’s how to use hedge strategies to avail margin benefits

August 24, 2021 12:53 PM

In December 2020, SEBI started implementing peak margin reporting in the equity cash and F&O, currency F&O, and commodity F&O segments.

SEBI Margin tradingNaked positions, such as long/short futures and short options, have unlimited risks and would soon require 100% margin. (Image: REUTERS)

By Abhishek Chinchalkar

In December 2020, SEBI started implementing peak margin reporting in the equity cash and F&O, currency F&O, and commodity F&O segments. The move has been carried out in four phases of quarterly, 25 percent increment, reaching 100 percent by September 2021. This would mean that effective September 1, 100 percent of the total margin would be required for initiating even intraday positions. While this would have no impact on positional traders, intraday traders would have to pay a much higher margin. But it is not all gloom here as there exist several hedge strategies with which one can avail margin benefits.

Naked positions, such as long/short futures and short options, have unlimited risks and would soon require 100% margin. However, what if instead of going only long futures, you also buy a put option having the same underlying, quantity, and expiry? Well, in that case, the risk would reduce significantly. This is because if the underlying declines, the losses that the long futures position suffers would be offset by the gains that the long put position makes. What we have here is a hedge (long put acting as a hedge to long futures). This strategy is called a Protective Put. While buying a naked Nifty futures position requires an overnight margin of over a lac rupees, did you know that hedging it by buying a Put option reduces the total margin by nearly two-thirds?

There are several such hedging strategies that could be deployed to lower the margins for a position.  To cite a few keeping Nifty and the July monthly contract as reference; selling a 15800CE requires a margin of around Rs 93,000. Furthermore, selling a naked call option exposes one to potentially unlimited risk. But what if one simultaneously buys a 15600CE? Well, doing so would not only limit the risk, but it would also lower the total margin needed to just under Rs 30,000  (including the premium of the long call). This represents a margin reduction of around 70%! This two-legged strategy is known as the Bull Call Spread.

Let us now take another example. Selling an ATM 15700CE and 15700PE requires a combined margin of around Rs 1.14 lakh. This strategy of selling a Call and a Put having the same, ATM strike is known as Short Straddle. Once initiated, a Short Straddle benefits if the underlying consolidates near the strike price and volatility shrinks. However, as this strategy exposes one to unlimited risk, if there is an unexpected pickup in volatility and the underlying starts trending sharply, the losses could get catastrophic, if not managed well. Such a risk could be reduced by adding wings to the Short Straddle, which is by buying an OTM Put and an OTM Call. Let us say we buy a 15500PE and a 15900CE. Adding these two legs would not only limit the risk but would also reduce the total margin required to around Rs 50,000, representing a margin reduction of more than 50%! This four-legged strategy is known as Short Iron Butterfly.

As can be seen from the above, the benefits of a hedging strategy are two-folds. One is that the overall margin required can reduce substantially, while the other is that the risk can also reduce significantly. Having said that, there are drawbacks too. By deploying a hedging strategy, the profit potential and the probability of profit also tends to reduce. For instance, in case of the Short Straddle strategy above, the maximum potential profit of the strategy is around Rs 17,500 while the probability of profit is around 55%. On the other hand, deploying a Short Iron Butterfly above instead of a Short Straddle would lower the maximum profit to just around Rs 8,000 and the probability of profit to just around 27%. You need to take this into consideration.

Hence, there is a trade-off when initiating a hedging strategy. You need to diligently assess the pros and the cons of the strategy before deciding to initiate one. These include looking at the risk/reward structure of the strategy, the payoff, your view on the underlying instrument, your expectations of volatility, the probability of profit, the margin required, etc.

Concluding….

Despite the unpopularity of SEBI’s peak margin rules, retail traders can avail extra leverage due to the reduced margin requirements for hedged positions. This is a big boon to traders as it helps them to deploy their trading capital more efficiently and increase the return on capital too. The reduced margin requirements allow traders with low capital to diversify their risk across various symbols, strategies, and strike prices.

(Abhishek Chinchalkar is a CMT Charterholder and Head of Education at FYERS. The views expressed are the author’s own. Please consult your financial advisor before investing.)

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