14.1: Framework of new margin

These are exciting times, especially for options traders in India.

NSE's new margin framework, which reduces the margin requirement for hedged positions, is now live.

You may be wondering what a hedged position is. This topic has been covered several times in this module. However, for the sake this chapter, we will briefly discuss it again.

Imagine that you're riding your bike at 75Kms an hour without a helmet. You suddenly come across a pothole. You slam on the brakes to reduce speed but it's too late. You crash and fall. How likely is it that you will injure your head? It is quite high, considering that you don't wear a helmet.

Imagine the situation again, except that you are now more cautious and wear a helmet. What is the chance of your head being injures by the impact? It is very unlikely, right? Because it protects you against injury.

The helmet serves as a protection against potential disasters.

The naked futures and options positions in the market are similar to riding a bicycle without a helmet. High risk of capital erosion and market-moving against you is possible.

But, the risk of capital loss is greatly reduced if you hedge your position.

Think about this: If your capital loss is small, it means that your broker's risk is low. If the broker's risk is lower, it means that the exchange risk is also reduced.

What does this all mean for you as a trader, then?

The critical margin dynamics is that the greater the risk, the smaller the margin requirement. The margin requirement is higher for those with greater risk.

This means that if you start a hedged strategy, your broker will block less margins than the margin required to open a naked position.

NSE proposed the same thing in the new margin framework.

For more information, you can visit this presentation from NSE.

This presentation is very technical. You don't have to be a rocket scientist to understand it unless you want.

Three key takeaways for traders from the new Margin Policy are highlighted on one slide. Here is a snapshot:
(IMAGE 1)
 

Start at the top

• Portfolio 1 – Margins have increased for naked, unhedged positions from 16.7% to 18.5%
• Portfolio 2 - 70% decrease in margins for market neutral positions
• Portfolio 3 - 80% decrease in spread margins

What does this all mean for you as an option trader?

Some of these strategies that looked good on paper, but were difficult to implement because they required too much margin, are now attractive.

Here's a trick question: Why do you believe spread position margin reductions are higher than neutral market positions?

Take a moment to think about it, and then post your responses in the comments section.

Given this, I'd like to talk about one more option strategy in this module. I didn't discuss it before because the margin requirement was extremely high. But now it's not.

14.2 - What is Iron Condor?

The iron condor can be used as a four-legged alternative. The iron condor is a improvisation that takes precedence over the short strangle.

Take a look at these -
 

This screenshot is from sensibull strategy. Nifty is currently at 9972.9. I am trying to establish a short strangle using OTM calls and put.

• 9800 Put at 165.25
• 10100 Call at (145.25)

Because both options are written/sold I can collect a total premium equal to 164.25 +145.25 = 309.5

If you are not familiar with strangles, I suggest that you read this chapter.

This short strangle setup has the following benefits:
(image 2
 

This strategy is my favorite because it allows me to retain the premium provided Nifty remains within a certain range. It almost always does. This strategy is also great for trading volatility. If you feel that volatility has risen (usually around major market events), then you should be an options seller to pocket the premiums. For such trades, short strangles are ideal.

You can sell/write options and get a net premium credit in a very short strangle. This case results in a premium of Rs. 23,288/-
(immage 3).
 

The exposed ends are the only problem with short strangles. If the underlying asset moves in any direction, the strategy will bleed.

This particular strangle, for example, has a safety range between 9490 to 10411.

Although I think this is a large enough range, markets have shown that it can make wild moves in a short time. Recent examples include the COVID-19 crash, which occurred in early 2020. This was followed by a quick recovery from the lows.

The potential loss if you get caught in a market move so rapid can be catastrophic and could wipe out your account. The broker and you are at risk because there is no limit to the potential loss. This eventually leads to higher margins.

(image 4)

A short strangle can be set up with a margin of nearly 1.45L. This is prohibitive for many traders.

This does not mean you should give up on the short strangle. An iron condor is an alternative to the short strangle.

Iron condors can make a quick strangle by plugging in their open ends. An iron condor is composed of three parts.

• Part 1: Set up a short strangle using a slightly OTM Call-and-Pu option
• Part 2 - To protect your short call against a large market rally, buy a second OTM Call
• Part 3 - Purchase a third OTM Put in order to protect the short Put from a huge market decline

This makes the iron condor a strategy with four legs. Let's see how it looks.

• Part 1: Sell 9800 PE at 165.25 and a 10100CE @ 145.25 to collect a premium at 310.5 or Rs.23.288/-
• Part 2 - Purchase 10300 CE at the 77 to secure the short 10100 CE
• Part 3 - 9600 PE bought at 105.05 for the protection of the 9800 PE

This is how the trade setup looks.
(image 5)
 

This is how the short option premium can be viewed: It finances long-term options.

The profit potential is reduced if you buy two options to protect yourself against two short options.
(image 6)
 

You can see that the maximum profit is Rs.9,634/=, but there are lower stress levels.

The maximum loss is now limited to Rs.5,366, but not unlimited. This is, in my opinion, amazing because I have visibility into risk and it isn't open-ended.

Profit is limited as long as Nifty remains within a certain range (in this case, between 9672 to 10228). The range has decreased in comparison to the shorter strangle.

This is how an iron condor pays off.
(image 7)
 

What do you think of the risk? This is the complete definition of the risk. The worst-case scenario is clearly visible to you. What does this mean for you, as a trader? And what does it translate into for the broker?

It is obvious that the risk is known, so the margins are lower.
(image 8).
 

The new NSE margin framework comes in to play here. Iron condors require you to pay an upfront cost of Rs.44303/-. This contrasts with the Rs.1.45L margin requirement for short strangles.

Retail traders were not able to execute an iron condor before the new margin framework. The margin requirement for an Iron Condor in these premiums and strikes was approximately 2 to 2.2L.

14.3- Maximum Profit & Loss

You should remember a few things when you execute an iron condor.

1. You should ensure that the PE and CE you purchase have equal strike distributions from the sold strike. Here, we have sold 9800 CE and 10,100 PE. We protected the strikes by going long with 9600 PE, and 10,300 CE. The difference between 9800 and 9600 PE is 200, while 10,100 CE or 10,300 CE is 200. Spread should be equal. I can't protect 9800 PE with 9700 PE (difference 100), and then protect 10,100 CE by purchasing 10,300 CE (difference 200).
2. When the market moves above long CE (i.e. 10,300 CE, or moves below long PE 9,600PE
3. Spread = 200 The difference between the protective strike and the sold strike.
4. Max profit = Total premium received. It is 128.45 (9634/75).
5. Maximum loss = Spread-Net premium received. It is 200 - 128.45 = 71.454

For more information, I suggest that you refer to the excel sheet at end of chapter. Note that the Excel sheet was updated 2 days after I wrote the chapter. The values may be different.

14.4- Concept of ROI and Logistics

A short strangle will give you a premium of Rs.23.288/-, while the iron condor premium receivable would be Rs.9,643/. In absolute Rupees the premium inflow for the iron condor is much lower than that of its counterpart. The ROI of the Iron condor is flipped when you compare this to the margin requirement.

A margin of Rs.1,45,000.90 is required for short strangle. The ROI is therefore -

23,288/1.45,090

=16%

Iron condors require a margin of Rs. 44,303/-. The ROI is therefore -

9,643/44.303

= 21%

Traders need to consider ROI, not absolute numbers. Margin benefits make a big difference.

This is where the sequence of trade execution really matters. Here is the trade sequence for an iron condor.

• Purchase the far OTM option
• You can sell the OTM Call option
• Purchase the OTM PUT
• Sell the OTM-PUT option

This is because you must have a long position before you can start a short one.

Why? Why?

Please note that I have only taken into account the margin for the ROI calculation. I have not taken into consideration the money you paid to purchase the options or the money you received when writing an option.

As traders, I urge you to consider different strikes for long positions. See what happens to premium receivable, breakeven point, and maximum loss.

Post your questions and observations below.

Keypoints

• The new NSE margin framework lowers the margin requirement to market neutral and hedged strategies
• The short strangle is a great strategy but it can also lead to unlimited losses.
• The iron condor is a improvisation of the short strangle
• Iron condors have long OTM calls, and puts that protect the ends of the short strangle.
• A short strangle requires far less margin than an iron condor.