Akash Jha
Leverage
When an equity or F&O trader takes a position greater in value than the funds or margins available in their account, such positions are said to be leveraged. This is typically done with the idea of generating a higher return on capital, but it entails taking a higher risk. Leveraged trades also give the ability to take a short view of a stock or the market, i.e., to profit from a trading idea that predicts stock prices going down. Using F&O, a trader using leverage can also hope to generate returns by predicting volatility, arbitraging, and employing more such strategies. F&O is also used to hedge either a single stock or an entire portfolio. In the case of F&O, leverage is baked into the product, unlike in equity.
Here are some examples of how leverage lowers the fund requirement to enter certain trades.
- In order to short 100 shares of stock X trading at Rs.1000 intraday with 5X leverage (20% margin requirement), one would need to have only Rs.20,000 in margin.
- Nifty futures (lot size 50) are currently trading at 17,000. In order to purchase one lot, one would require around 12% of the contract value, or Rs.1,02,000 (contract value = 17000 * 50 = 8,50,000). Due to the inherent nature of leverage in F&O contracts, it is not possible to pay the whole contract amount of Rs.8,50,000 and trade without leverage.
- Like futures, options writing (shorting) requires only a small margin of the contract value.
- In contrast to intraday stock, futures, or short options, where losses might be unlimited, option buyers’ maximum exposure is the amount of the option’s premium. So, although buying options may appear to be a non-leveraged trade, it is actually the most risky and leveraged instrument possible.Let me elaborate. The premium of Rs 5000 (50 times Rs 100) is needed to purchase one lot of Nifty 17000 calls. However, for a payment of Rs 5,000, the position’s exposure is Rs 170,000 times leverage, or Rs 8,500,000. Contract exposure value of Rs 8.5lks determines how quickly you can lose Rs 5000, the maximum loss. Wow, that’s quick!
Leveraged trades contribute to over 90% of exchange trading volumes, but most of these volumes are from just about ~15% of active traders. Leveraged trades provide significant liquidity, cushioning volatility during events, and significantly help reduce impact costs for investors.
Margins
Since the exposure in a leveraged trade (other than option purchasing) exceeds the amount of capital at risk, a trader can theoretically lose more than what was originally invested. If a trader with only Rs 20,000 in their account acquired 100 shares of stock X for Rs 1000 and the stock’s price suddenly dropped from Rs 1000 to Rs 500, the trader would lose Rs 50,000. The brokerage company is responsible for covering the remaining Rs 30,000 in losses, since the trader only has Rs 20,000 in liquid assets.
If tens of thousands of consumers all suffered losses from the same stock, and the brokerage firm was not sufficiently capitalised to collect the debits from customers, the entire market would be at risk. Naturally, the more leverage used, the greater the potential for loss. The broker and the markets as a whole benefit, not just the individual trader.
Brokers are obligated by authorities to collect a minimum margin for all leveraged deals in order to mitigate this risk. For equities, this minimal margin is known as VAR+ELM (Extreme Loss Margin), while for F&O, it is known as SPAN+Exposure. Until until last year, brokers may choose whether or not to offer intraday traders leverage above and beyond the minimum. This was a major selling feature for numerous businesses. Since peak margin laws have been implemented, this is no longer practicable, and margin standards are now standard across the industry.
You can use our margin calculator to determine the minimum margin or leverage needed to trade with us in equities, currencies, and commodities. If you’re interested in learning more about the evolution of margin calls across time, you may do so by reading this post.
Margin penalty
A margin penalty is a tool used by authorities to guarantee the collection of required margins. Up until last year, the minimum margin was solely applicable to EOD positions. This meant that, at the close of business, the trading account had to have at least the required margin for all open positions. Margin requirements were not monitored in real time by the exchanges. If the necessary margins weren’t available by the close of trade, a fee would be assessed. Since intraday peak margin checks were implemented, the penalty now also applies to margin deficits that occur during the trading day.
The clearing company (CC) checks the availability of margin five times throughout the day by randomly sampling customers’ intraday positions and margins. When intraday snapshots or the conclusion of the trading day reveal that margin requirements have not been met, a margin penalty is assessed on the net shortfall amount. The fine is 0.5% of the amount by which the shortfall falls short of Rs 1L, and 1% of the amount by which it exceeds Rs 1L. If there are more than three instances of a shortage in a given month, the penalty can increase to 5%. Traders are fined and the money goes into the exchange’s core Settlement Guarantee Fund (core SGF).
When discussing margin fines, two distinct varieties exist.
Upfront margin penalty
If a trader doesn’t have enough margin in their account, this is what happens. If a broker allows a client to enter a position with a minimum margin (SPAN + Exposure) of Rs 1.1L but the client only has Rs 1L in their account, the client would be charged a penalty equal to the difference, or Rs 10,000.
Non-upfront margin penalty
Non-upfront margins are theoretically all margins that must be collected after a client conducts a deal (after meeting the upfront margin requirement). In the event that the customer does not timely fund such increased margin requirements, a shortfall occurs and a penalty may be imposed. For instance, if a futures contract experiences marked-to-market (MTM) losses, the trader has until T+1 day to make up for the shortfall or face a penalty. Non-upfront margins also include volatility margins and physical delivery margins, both of which are added by exchanges to stock F&O contracts in the week before they expire.
Below are some concrete illustrations of both immediate and delayed margin penalties.
Who bears the margin penalty?
A broker should take the hit if a client trades without enough initial margins. If a client takes a transaction and then fails to meet the necessary margin criteria, it is the customer’s responsibility to do so. Brokers are prohibited from passing on to their clients the upfront portion of any margin penalty, but may do so with the non-upfront portion.
In derivatives (F&O, CDS, MCX), this is where things start to get complicated. Since the peak margin penalty was implemented last year, the broker is now responsible for making up any shortfall in upfront margin, even if it occurs after the trade has been entered, should the margin requirements increase as a result of volatile market conditions.
Because the option reduces the futures position’s exposure to risk, the margin requirement for a customer holding Buy Nifty futures and a Buy Nifty put is just Rs 25k. Futures margin returns to Rs 1 lk if put position is liquidated. The consumer has committed an upfront margin breach if their margins are currently below Rs 1L. Similarly, if the customer’s F&O portfolio ends the day with a higher margin requirement than was anticipated by the broker, then that is also called an upfront margin shortfall. When shorting options, unlike futures, there is no such thing as marked-to-market losses that must be covered by the next trading day. There is an up-front margin penalty that occurs whenever a short option incurs a loss.
In the aforementioned cases, most brokers had taken the position that any penalty on shortfalls due to unpredictable market volatility or any other reason after taking a position is not an upfront margin penalty but non-upfront, and could therefore be passed on to the customer who took the position. Customers in this situation are often notified of the margin shortage and asked to make a deposit or liquidate some positions.
However, stock exchanges recently produced a circular declaring that such situations qualify as instances of upfront margin fines, and that brokers should not pass them on to customers. Since the implementation of peak margin penalties in October 2021, brokers have been instructed to return all such prepayment penalties to their clients.
Since it is impossible for brokers to ensure compliance in situations where the margin requirement changes post-trade due to unpredictable market conditions, broker associations and individual brokers have been consulting with exchanges and SEBI to better understand this anomaly. Customers who are confident in their own agency are the only ones who can. After discovering one such irregularity, SEBI issued a new circular effective as of August 2022 that eliminates the consideration of intraday margin rise when determining peak margin penalties. However, this does not account for every possible situation.
As of August 2022, Zerodha will no longer charge clients for upfront margin penalties following a trade. In addition, we have been calculating and returning to clients any passed-on upfront margin penalties dating back to October 2021. You can submit a ticket if you feel you should have been refunded but haven’t. Non-upfront margin penalties will not be repaid, only upfront ones.
My opinion, which may be skewed given I am the CEO of a brokerage firm, is that it is terrible that brokers must pay these fines despite having met all regulatory requirements for pre-trade margin availability. This occurs despite tools designed to inform consumers of intraday shortages due to volatility in the market. We are working on a feature for our RMS that will prevent the closing of any trade if the post-exit margin is more than the available funds. We are also attempting to immediately square off trades when the margin rises and no available funds exist. While the RMS transition is a difficult technology challenge, rushing to resolve differences without consulting consumers first is certain to cause friction.
If the F&O portfolio’s margin rises because of volatility or, in the case of option writing, because the customer’s position has shifted adversely, they should have until T+1 day to bring in more margins. Similar to Futures, where losses from markdowns can be shifted till T+1. It is the responsibility of the customer, not the broker, to comply with this rule if closing out a position causes a rise in margins.
This post should clear up any confusion you may have had about margin trading and margin penalties on Indian exchanges.
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