The SEBI circular issued on October 1 has made several changes to derivatives trading. Take the permitted lot size for index derivatives, which is currently fixed such that the contract value is between ₹5 lakh and ₹10 lakh. The revised contract value, which will take effect from November 20, will be between ₹10 lakh and ₹15 lakh. This week, we discuss the potential impact of the revision in contract value on trading strategies.
Spreads better?
An increase in contract value will lead to an increase in permitted lot size. But importantly, the increase in contract value will mean higher margin requirement. So, the capital required to trade derivatives is likely to increase.
Will this bias take traders towards spreads instead of plain-vanilla long or short futures positions? For instance, at the time of writing this article, going long on the near-month Nifty futures required an initial margin of ₹70,000. But if you were to add a short out-of-the-money (OTM), say, 25200 near-month Nifty call to the long futures position, your combined margin would be about ₹83,000. True, your margin is higher than for a plain-vanilla long futures position, but you can capture greater profits depending on your view of the underlying. Suppose you expect the underlying to move up gradually till contract expiry. Also, suppose you expect the index to face stiff resistance below 25200. Then, long futures short OTM call position could be gainful.
But what if your objective is to reduce margin requirements using options? Note that margin on options are levied only when you initiate short positions; for, long positions require you to pay upfront premium. Suppose you want to short the near-month 25000 Nifty call. Based on current regulations, your margin would amount to ₹62,000. But what if you combine a long position on, say, the 25500 call of the same expiry? Your margin requirement comes down by ₹42,000. But your initial outflow will increase by ₹3,500; the price you must pay to buy the 25500 call. That is, indeed, a significant cost to save ₹42,000 of margin — one which most traders may be unwilling to do. Why? Margin is not a cost but a cash outflow which will be credited into your account when you close the trade. Going long on a call is a cost, and the position will lose value with each passing day because of time decay. The above argument, though limited in its scope, suggests that traders may not be biased towards option spreads when margins increase.
Optional reading
It is likely that many traders may switch to long options instead of long futures. But that may not be optimal because the choice between options and futures should not be based on margin requirements. Rather, it must be based on your view of the underlying; if you are confident of a breakout of the underlying, futures may be more gainful despite higher margins because of its near one-to-one movement with the underlying.
The author offers training programmes for individuals to manage their personal investments