The superiority of spreads and their absolutely dismal state

General
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Exposure margin is an additional margin charged on top of SPAN margin for the purpose of risk management. And it probably makes sense for unlimited risk products such as naked futures and naked short options but those are not popular amongst retail traders now because of the heavy margins associated with them. Most traders seem to have moved to option buying which does excite them as it is a limited risk and unlimited profit product. And because of this shift in product choice to a limited risk product, brokers also must be at ease I guess cause their clients can never run into a negative balance with long options regardless of what bets they make. Clients are happy and so are the brokers. But we know for a fact, achieving success in trading is very hard and for options buyers, time makes it harder in the form of theta decay. Point being that naked option buying might give you a jackpot or two but at the end of the day, it’s not a consistent way of making money. The only consistent way to make money in options in my opinion is not to buy naked options but rather create spreads. That way, you are able offset the theta decay by a great degree and not only that, you end up reducing the cost basis of your long option and thus, reducing maximum risk as well. And in terms of reward, good profits can be reaped in a consistent manner rather than trying to hit jackpots every now and then. All in all, spreads are the superior product. They also enable you to sell options in the form of credit spreads but without the unlimited risk part. Retailers too can sell options without too much risk with the help of spreads.

But alas, spreads are not very popular and people don’t utilise them despite spreads offering several more advantages than naked option trading. There are several reasons behind their unpopularity but one major reason that stands out is regulatory framework.

The current rules require that exposure margin be charged on the short option of a spread. So, for example -

If you create a debit spread having 25000 as the max risk, you will need to shell out an extra 35000 to create this spread considering that 3.5% of the contract value is being charged as exposure margin.

Now, does it make sense? How can exposure margin itself exceed the maximum risk that is involved in the trade? The global standard says that a limited risk strategy such as a simple debit spread will have only its max loss(which is its net debit value btw) as the only margin requirement. This is what is followed in the US
as well. You are not charged above the max loss. But in India, we being charged more than twice the amount of the max loss. It’s illogical in my opinion.

Also, by the definition of exposure margin itself, it cannot be applied to spreads. Exposure margin, if I am not wrong, acts in when SPAN margin fails. It also goes by the name of ‘extreme loss margin’ for that matter. How can exposure margin be applied when you are trading a limited risk strategy. In the most extreme scenario also, your loss cannot exceed the supposed max loss.

Now, you might ask what would happen if a trader closes only one of the legs and not the other one. That would certainly expose him to a risk greater than his initial max loss. Yeah, that’s true but we have to understand the implications of this. We are basically talking about the possibility of negative balance here. That’s the broker’s biggest fear right? But that’s not a thing with most clients in the first place. Most clients wouldn’t close their long options first cause they know peak margin penalty would become applicable and they also run the risk of having their short option running naked. Also, if they closed their short option first for a loss and they had liquid cash in their account to cover for that loss, then also it’s not a problem even if the hedge is broken and the long option is allowed to run naked, because they already covered for their incurred loss. So, the solution is simple. A client cannot break his hedge by himself if doing so results in a negative balance. Basically, he gets ‘nudged’. He gets informed by the broker through a notification or something that what they are about to do might result in a negative balance for them. It’s just so that they are well informed of what they are about to do. They should also be made aware that they must close both of their positions simultaneously and failing to do so will automatically result in the RMS closing off the remaining position. I think it’s that simple. Charging exposure margin from every single client is simply excessive in my opinion considering not everyone is that stupid. Removing exposure margin for spreads and introducing a broker assisted notification for clients that might pose a risk is the solution in my opinion and the way forward.

I request @nithin to please go through my post and provide feedback to my suggestion and if possible, have my suggestion be taken up with SEBI for consideration. I think my suggestion if implemented would greatly help the retail community as it would encourage people to create spreads instead of playing with naked options. It would instill a sense amongst retailers for logical plays in the market rather than attempting to hit a six on every bet.

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Not true. Thanks to the physical delivery of stock options, we have had a bunch of customers buying options and accounts going into a debit balance. This happens when an OTM suddenly turns ITM in the last 1 hour on an expiry day.

But yeah that apart, options are safer for brokers in the short term. But since the odds of customers making profits buying options is lesser, in the long run, customers have a high chance of losing, which isn’t good for the brokers as well.

What you are asking for would be possible only when the strategies themselves start trading on the exchange. A broker nudging customers may or may not work if someone is exiting the long leg of a strategy first. The margin requirements are usually calculated based on worst-case outcomes. The other issue with a strategy could be that one of the short legs might get illiquid, so no option to exit it. This type of execution risk is the reason why exposure margin is asked.

We have taken this up with the regulators multiple times, but there is no way to address this concern of theirs. Removing the exposure margin on strategies will expose brokers and the markets in all to risk. The risk isn’t really going to be from retail investors, but from large traders who might have lakhs of contracts and hundreds of crores in exposure margin.

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  1. What exactly does it mean when you say that the spreads themselves start trading on the exchange? As far as I know, you can execute spreads as a single order in the US as they have a complex order book. But that’s a thing just so traders are able to execute both the legs of their strategy simultaneously without much slippage. One can also create a spread by entering both the legs separately. But the end result is the same. How does it relate to the problem of exposure margin?

  2. My idea is basically that you need to have sufficient margin in your account in order to close one of the legs in your spread. Otherwise, the order gets rejected. If someone tries to close their long leg first but they do not have sufficient margin to cover for the margin requirements of their remaining naked short option, the order cannot go through and the client will he informed why their order got rejected. Same can be done in the case wherein someone tries to close their short option first. If the short option is in loss, then that means that the debit now required to pay for that option now exceeds the credit received initially. And since it requires a debit to be paid, the client must have sufficient margin to cover for this debit. Otherwise, the order gets rejected and similarly, the client will be informed why their order got rejected. I am not saying that the client simply gets ‘nudged’ for what they are doing but rather safe execution is actually enforced by the broker. Basically a model where margin is required to close your positions just like margin is required to open poostions.

  3. Your concern regarding short strike being illiquid is valid but how does it relate to exposure margin? If a client is not able to exit his short option due to illiquidity, then that’s a liquidity problem. How is exposure margin doing anything to protect you from illiquidity? If the concern is regarding huge slippages associated with illiquidity, then like I said in the above point. You must have sufficient margin to close your positions.

Apart from the above points, there comes a situation wherein a client has only 25000 and he executes a spread with that entire amount. I am just taking a hypothetical example. Now, he doesn’t have any margin left to close his spread of it were to go ITM. Apart from that one situation, there is really no other case wherein it might be a problem. But even in that case, perhaps there could be an option provided where the client can avail broker’s assistance in closing their spreads. Basically, if a client cannot close his spread due to insufficient margins(usually would be someone who is just starting out), they can take a broker assisted trade. The broker on behalf of the client will close both the legs without much slippage. That’s why my idea is at least.

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Even in the US option spreads don’t directly trade on the exchange. If the spreads did trade there won’t be any execution risk of not being able to exit one leg. Currently, calendar spreads of the future are the only thing that trades directly on the exchange.

Margins are collected to cover the risk. Higher the risk, higher the margin & vice versa. By collecting exposure margin the regulator’s expectation is that it is covering for the execution risk or one of the legs not being exited in a spread.

Currently, the exchange or broker systems don’t have the ability to block exits of positions because the margin post an exit isn’t sufficient. While this is on our list of things to do at Zerodha, unless an exchange/clearing corporation implements this, regulations can’t define a rule around it.

By the way, there have been enough discussions around this with the regulator. The margins for spread did drop when the new margin requirements were put in place. But I don’t know if it can go down lower from here given the current limitations in terms of not being able to have spreads trade as a single product on the exchange or inability to monitor margins post exit of a position & blocking exits if margin is insufficient.

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But is it technically possible to implement what I am asking? As far as information technology goes, nothing is impossible as has been observed through all this time that it has existed. I am not asking you to act against the regulator and have it force willed to implement such a regulation. I am only asking you to help me know what’s possible and impart a sense of clarity and refinement in my idea. So do let me know what’s the feasibility of it.

Apart from this, I need to ask one more thing. What’s the need for brokers to charge MTM for short options in the case of spreads? I asked about this practice earlier and the moderator said that it is not mandated by the exchange or the regulator to collect MTM for losing short options if you have it hedged. Then why bother taking MTM for hedged positions? The client is already paying so much in exposure margin, which is technically speaking is exactly for the purpose of covering losses of short options. It’s kinda detrimental to the client don’t you think. If a client wants to manage his risk in a spread for example and he wants to make adjustment trades, but his free margin is getting blocked from the broker side, then he won’t have free cash to make adjustment trades. Adjustment trades are some advanced hedging techniques that I’d say pro traders use. Without such techniques, success in trading such products becomes much lower. Lower success with a particular product and the hassles associated with it compared to what could have been a lot better with the same product would only lead to that product remaining unpopular. If people were to start trading spreads for real, they would find themselves losing a lot less and also making small consistent profits which in turn would lead these clients to stick around in the long run. Client retention isn’t strong suite in the broking business but limited risk plays have the potentional to change that. It’s a win-win for both the client as well as the broker. So, can you please consider not charging MTM unnecessarily from the free margin in the case of spreads. This decision at least rests with the brokers and not the regulator. So please, can you make it a thing on your platform and perhaps other brokers might follow along? Thanks.

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We are working on implementing this at Zerodha, which is blocking the exit of positions unless the margins post-exit is sufficient to hold the open position. But I don’t think the industry is ready yet. This isn’t an easy tech problem to solve.

Firstly, all margin requirements across the industry are as stipulated by exchanges/regulators. We definitely wouldn’t be asking for margins more than the minimum required as per regulations. Almost the entire industry uses the risk management system of Thomson Reuters (Now London stock exchange) or 63 moons, so the margin requirements will have to be similar.

Btw in the case of short options, there isn’t really an MTM of sorts like in future. What happens is that when the short option goes against you, the margin required to hold the positions go up. So yeah, the margin for the spread also can go up with this. Again, this is as per what is stipulated, no option with the broker.

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But it’s hedged. That’s the whole point of hedging. If the short option increases in value, so would the long option. That would offset the losses in short option automatically. Only in the case of exposure margin changing due to fluctuations, it makes sense to deduct that minor increase in exposure margin.

I am not talking about increase in exposure margin due to fluctuations in the underlying. That would obviously be deducted from the free margin. I am talking about the situation wherein the long option is gaining but the short option is losing and the unreliased loss associated with the short option is being deducted actively from the free margin. Is that a thing? And if that’s a thing, can it be removed? Cause then there would be no point to a limited risk strategy if it’s not treated as such.

(@nithin, would kindly request you reply to this one last query.)

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Unfortunately doesn’t work that way. Premium value going up for long options doesn’t negate the margin going up for short options. Margins going up have to be brought in actual cash. This again is not in control of the broker, exchanges/clearing corp have the same framework for everyone.

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I am not talking from margin perspective but there are platforms which provide spread execution and some of them even ensure that all the legs are completely executed at exchange level .These are very common in trading desks and prop firms and i am sure you guys would also be using or used them. Some of them which I am aware of are popularily known as convex or Greek among traders.
What I am asking is how they (not all obviously ) completely ensure that all the legs get filled. I used to believe that exchange might have some mechanism to directly support some of spread orders but since you mentioned that they do not. And I can’t just assume that softwares algo to only to take care of this issue . So can you through some light on what I might be missing.

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I don’t think that’s a thing in India. You aren’t talking about India right but rather the US? Then I can explain.

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Hmmm… Ok. But that inevitably leads to 2 more queries. Sorry for bothering so much but there’s no other source that would provide this information. So please bear with me,

  1. Do the positions get squared off by the broker in case the client is not able to provide for free margin for unrealised losses in the short option of a spread?

  2. What practice does US follow? Do they also charge M2M for short options just like in India? I know they don’t charge exposure margin but I just want to know what’s the case regarding M2M.

And thanks for taking the time to respond to my queries. No one else would have been able to clarify in such an accurate and timely manner. Really appreciate.

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It’s india. What I missed in reply was that I am talking about execution of spread in pre determined price. For example you are executing long iron condor for a ₹10 debit so you will put a price of ten in the terminal and all position will get executed at max debit of ten or maybe less.
Only nithin ji would be able to clarify on this.

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That’s not a thing is India as far as I know cause that requires a complex order book. Basically, when you enter a debit spread for example and you want it at a particular value, it goes to the complex order book at the exchange and someone who is willing to take counter to your spread will have his order matched with yours and that’s how your order executes. It’s a thing in the US cause over there, they have market makers which are willing to fill your orders. They manage their risk actively and use high frequency techniques and what not to make a profit. Basically they are providing liquidity. In India, complex order book is not a thing so far as I know. Where did you get this information?

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Nopes, there is no retail platform that allows this to be done. This type of trade is considered as an algo and needs exchange approvals. There will be prop desks who might have created their own algorithms for their personal use. So essentially the program is tracking the market depth of multiple contracts and when the combination is a certain price, it triggers a buy on all of the contracts. But again, from the time the algo detects the price of the combination to be a certain price to order execution, there could be slippages in the strategy.

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  1. If the margin required to hold positions exceeds what is available in the account, exchanges start levying margin penalty on that. So yes, if you don’t provide for free cash for the increase in margin, the position can get squared of. But in a strategy, the loss of short leg necessarily need not be the additional margin required. Margin goes up slower if your short position is hedged.

  2. The SPAN way of calculating margins is built by CME and is pretty much the standard way of calculating margins across all exchanges around the world. Like you correctly mentioned, the Exposure margin charged in India is over and above SPAN margin, so only this is specific to India. So the way SPAN margins get charged for option strategies and the requirement of additional margin when short positions go deeper ITM (this isn’t really M2M, in M2M full losses are required to be brought in, like in futures) is similar.

Btw, even in the US the margin requirements aren’t as less as most people talk about here in the Indian trading community. For example, many brokers in the US don’t allow you to short naked calls or naked puts unless you have full contract value in collateral in case of calls and actual stock in case of puts. Similar to exposure margin, almost every broker charges an additional margin over and above the minimum margins that SPAN calculation requires. Also in the US, it isn’t easy for clients to default on the broker and getaway, so they can be more aggressive in terms of margin requirements.

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You just confused me even more now. Sorry, but it seems contradicting as to what you said just now and what you said previously in the posts.

From the way I understand it, there are few factors here pertaining to margin with regards to spreads -

  1. Let’s just say a debit spread is being created. Then the short leg is already hedged by a relatively ITM long option. Now, apart from the net debit value, we are required to bring in exposure margin as well. Now, if there is a change in exposure margin due to whatever reason, we are required to bring in that margin and failure to do would result in square cause this is the margin required to hold our position. Yes or no?

  2. Now, let’s take the same debit spread. If the price moves in my favor, then both options will gain value. The short option would be losing obviously but the long option would gain much more than the short option. Nonetheless, I assume from what you have earlier that we are required to pay for the losses in our short from our free margin. Is that correct? Yes or no?

  3. If we fail to pay for the losses of our short option for the same spread that I am taking as an example, does the broker square off our positions? Yes or no?

  4. What does it mean when you said that margin goes up slower in the case of a spread?

Sorry for dragging this on for too long but don’t think you are helping me only, you are helping everyone who would go through this thread as it would serve as a reference to everyone else who might have the same query.

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I think you can do this by getting a dealers terminal from broker. Am I right? There is something known as CTCL in trading softwares.
You might have to become ap for this but I don’t think it’s a difficult thing. Obviously it’s not a retail thing and not feasible for brokers working with your scale size (you can’t just start making people APs and give them terminal ) but it’s neither a very big issue as well. It’s as per my knowledge, there might be lot of things which I might be missing.

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Yes.

Yes. What I was telling you was that there is no concept of MTM for short option positions like in futures. Check this explanation.

In futures, whatever is the loss on one side is collected and paid to the client on the other side of the position. In options, the option buyer doesn’t get money credited like in futures if say the short option holder loses money. The way it works with short option trades is that when position goes against you, the margin required to hold the position increases & indirectly acts like MTM. The margins don’t necessarily go up as much as your loss. So for example if you short 1 Nifty 17200 calls at say Rs 100 and premium Rs 1lk. If the premium goes to Rs 200, the margin requirement to hold this may not be Rs 1.05 lks (Rs 1lk + Rs 5 loss), it could potentially be Rs 1.03lks. It depends on the SPAN.

Like I explained, if your margin to hold the spread goes up and if your account doesn’t have sufficient margins to hold it, yes, it will get squared off to avoid exchange penalty on the account.

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Dealer terminal doesn’t come with this feature. You will still have to build a platform or utility that uses broker APIs to be able to do this. Today customers of ours who use Kite connect APIs could potentially have built custom utilities to be able to do what you have mentioned.