Basics Of Options
Margins for Options Trading and Settlement
Finally, in this last section, we will learn the different types of margins in options trading and how options contracts are settled.
The investors who buy option contracts are required to maintain the margin requirements on the position. Based on the position taken by the investor, the margin requirement varies. Traditionally investors need to deposit 100% of the options premium in 2 business days after settlement but it has evolved gradually over the period.
Let’s understand margins involved in buying and selling of options:
We know that option buyers can have a limited loss or unlimited profit. On the other hand, option sellers face a situation of limited profit or unlimited losses.
Thus, option buyers in order to enjoy the upside or the downside as the case may be, and hence have to pay a certain premium to the option seller. While option sellers are required to pay margin money in order to create this position.
Margin money is often measured as a % of the total value of the open position. Option buyers can have a limited loss or unlimited profit thus required to pay the premium to enjoy the upside or the downside. On the other hand, option sellers may have a situation of limited profit or unlimited losses and hence they need to deposit margin.
Margin for options buyer
For the buyer, they need to pay only the premium and not the full price of the contract. The exchange transfers this premium to the broker of the option seller who in turn transfers it to the client.
So, the minimum loss to the option buyer is restricted to the premium amount.
Margin for options seller
The option seller, on the other hand, has a potential for unlimited loss.
Thus, the seller has to deposit margin with the exchange as a security in case of huge loss due to adverse price movement in the option price. This amount is levied on the contract value and the amount is denoted in % term as dictated by the exchange.
Usually, this % value is created based on the volatility of the price of the underlying asset and the option. Higher the volatility, higher is the premium.
Margin for options example
Mr. A sells 1 lot (lot size is 600 shares) of call option of Infosys. The premium received is Rs 10 for the strike price of 970 and we assume a margin of 20%.
The option position stands at 582000 (600 x 970). Thus, the margin amount is Rs 116400 (582000 x 20%).
Types of Margin
- Initial margin– It requires the minimum amount of capital or equity that an investor must provide during purchase. It is done to prevent over speculation and excessive trading. It is that margin requirement which investors talk about when dealing with margin trading.
Until there is enough margin in the account i.e. greater than or equal to the initial requirement, the investor can freely use his account. However, if the margin goes below the initial margin requirement, it will lead to a situation of restricted account which requires investors to bring back to the initial level.
- Maintenance margin– It is the minimum margin amount which an investor must maintain at all time in the margin account.
Say if the margin goes back below the maintenance margin level, the investor will get a call initially to remedy the position or else the broker has an authority to sell the required equity to bring back to the initial level.
It protects both investors and the brokerage house. The broker does not have to absorb excessive investor losses while the investor is in a situation to avoid being totally wiped out.
Options Margin calculator
An option can be settled either through physical settlement or through cash. In case of physical delivery, options require actual delivery of the underlying asset.
Whenever we sell or purchase any option, we can exit before the expiry date by taking an offsetting position in the market or we can hold the position till the maturity date where the clearinghouse settles the trade.