What if live risk management was made mandatory?

After having learnt about live risk management in detail from one of the mods, I am thinking why doesn’t SEBI make it mandatory across the board. That’s the best form of risk management in my opinion. Like, being proactive should be the way cause it can keep the entire system much healither. There would be no margin shortfalls as they would be collected on an intraday basis. You basically pay your dues if you wanna carry your position overnight. Simple as that. My agenda behind supporting this proactive risk management system is that SEBI can then lower the margin requirements without worries. So, basically not only the margins could get lower but the systematic risk at the same time would get much reduced. It’s a win-win.

So now, let’s get to the technicalities of things so that I can elaborate on what I am saying. Under the current framework, there is no proactive risk management mandated. Yes, big brokers like Zerodha do it but not everyone does it cause it’s not mandated. What you have is basically extremely high margins and that’s supposed to prevent you from ending up with negative balance. Now, let me explain the funda behind your margin requirements cause not many people know this.

So basically, there’s a thing called daily volatility and it’s specific to each scrip. And margins are computed on the basis of this only. So, let’s just say a stock has a daily volatility of 2%. It’s calculated by the exchange by the way and it gets updated daily. So, this 2% of volatility gets multiplied by a factor of 6 which results in 12%. Why the number 6? Cause there’s a concept of 6 sigma which basically means that this is the worst possible move in a single day, of all time we can say. Now, that is for one day only and SEBI wasn’t satisfied with worst possible single day move. And the reason is because it is mandated that the broker collects the MTM loss on T+0 day and that could be after the market closes as well when your loss for the day has been realised. Now, this is not live risk management as I have mentioned above. You are supposed to pay your MTM losses on the same day but what if you don’t? The broker cannot liquidate your position in a closed market. If you don’t pay for the shortfall, you will be charged a penalty of course but the broker has to carry forward your position to the next day and it is next day only that he can liquidate your position to cover up for the shortfall. So you see, your margin that you have paid is being exposed to 2 days of risk not 1. So, Sebi wanted that the risk should be accounted for 2 days instead. And what that means basically is that there is a 41.4% of buffer over the 12% of SPAN margin which bring the SPAN margin to 16.96%. On top of the Span margin, you pay an exposure margin as well of 3.5% which is for stocks which brings the total to 20.46%.

Now imagine, this stock has a volatility of 2% only on any given normal day. Yet, you are paying 20.46% margin. And on top of this, all the Mtm loss has to paid by you. So, you have to keep a buffer of 5% as well which basically means that you need 25.46% of contract value to buy a single futures contract. 2% volatility and 25.46% margin. And higher the volatility, higher the margin. You see, this 20.46% of margin that you are paying is doing nothing for you but sitting with the exchange. This is maintainance margin as it is called and yes, it is necessary cause it’s basically a deposit that you are making to cover up for your losses in case you fail to pay the counterpart in Mtm. But if it is unreasonably high, your ROI goes down and that’s one thing but markets also become less accessible to everyone cause not everyone is that well off.

Now, let’s come to the solution to this problem. I propose that the MPOR i.e. Margin period of risk is brought back to 1 day only. That is basically the biggest offender in the increase of margins. So, let’s do the maths again.
Daily volatility is 2%.
6 X 2 = 12% which is your Span margin.
No additional buffer over Span margin cause proposed MPOR is 1 day.
Exposure margin = 3.5%
Total margin is 15.5%.
Which is somewhat less than the 20.46% of total margin earlier.

Now, why am I proposing that the MPOR should be one day only? Cause you see, the MPOR was increased to 2 days cause there was no proactive risk management. Your position was being exposed to overnight risk.

What I am proposing now is a live risk management framework. What are features of this framework?

  1. It is compulsory that if a position falls by 50% during the day, it would be squared off the broker.

  2. At 3:15 PM, it is compulsory that all your Mtm loss for the day is paid by you and only then you will be allowed to carry forward your position. The broker has the right to square off at 3.15 PM if your losses are not paid by then.

  3. The onus of penalty will be on both the broker as well as the client. If there is a margin shortfall of any degree, applicable penalty will be applied basis the amount of shortfall to both the broker and the client.

  4. If there is a shortfall and the client fails to pay on T+0 day, the first thing broker shall do on the next day is to liquidate all or part of the client’s positions so as to recover towards the shortfall.

  5. The broker cannot retrieve his share of penalty from the client.

These points that I have mentioned above will make sure that risk management is done on a live basis and no client is allowed to carry forward without paying their dues.

All in all, if this is implemented, margins can come down to a small extent and systemic risk will also reduce greatly as the broker will now be actively responsible towards proper risk management.

Tagging @nithin.

Most brokers do risk management on a live basis itself.

While a lot of this can be easily done by online-only brokers like us, the broking business also has a lot of brokers working based on relationships. Brokers allow customers to bring in losses the next day, but of course, charge a much higher brokerage rate as well. Anyways with all the new regulations on upfront margin, no broker can anyways allow customers to enter positions without full margin (from Sep 1st even on an intraday basis).

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I know I wrote a massive block of text but I have read through it several read times to make sure that the reader gets what I am saying.
Essentially, what I am saying is that the reason why margins are so high right now is directly because the client can pay for his MTM losses after the market closes for the day, thus exposing his position to 2 days of risk if he doesn’t pay on the same day and the broker has to resort to liquidating his position on the next day. That’s where the MPOR of 2 days came from which basically adds a buffer to the Span margin in order to prevent negative balances. I am saying that SEBI should make it so that the possibility of a margin shortfall doesn’t occur in the first place. By making brokers proactive about risk management and basically enforcing the policy of “You pay your dues before carrying forward”, overnight risk would be greatly eliminated. Responsibility should be kept on brokers that client pays their MTM losses before the market closes and the right to square off their position if they fail to do so should be granted to them. But of course, no one’s gonna comply if there are no consequences. That’s why I am saying that if there is a shortfall, broker should also be held responsible and made to pay the same penalty as the client. It’s not going to affect brokers like Zerodha and their clients would then actually be happy cause some relief in margins could be provided. Additionally, it’s going to make futures somewhat more attractive and that might influence clients to trade futures rather than options which you know are far riskier cause of their volatility.

Position belongs to trader, profit or loss belongs to trader, broker is just a medium who lets users to take a trade. Broker does what they can in the best interest of client but end of the day it is client who should control/manage their positions.
Already brokers has too many things to manage, many compliances they need to handle, maybe I can say one of the most regulated industry.
Some rogue traders will be there who will break the hedge leg just before market closing and carry position for next day with lesser than required margin and ready to pay penalty, no risk system can stop that and one can’t blame broker for this.
Also look like you are new to fno trading or not observed margins before while trading , instead of reading on margins I would recommend you to trade, observe margins, use strategies to get the gist of managing margins and all, use hedge strategies so that there will be less risk and lower margins are required.

I am not new. I have been around since 2018 actually. I used to trade then. But I don’t trade currently cause of the enormous margins. So, I am a victim of stringent regulations you could say. I just want a better, more accessible market for everyone which I hope isn’t too much to ask for. And what else can I say… It all seems like a pipe dream to me.

To be frank for hedge strategies margins are decreased drastically now, ROI has improved considerably, just that one should have good trading plan to implement hedges to earn consistent reasonable money with out being too greedy. You can check on kite baskets how much is required now for hedge positions with out taking any trade.

Hedging is basically going risk neutral. You don’t go risk neutral on every trade. You do that only to like protect your existing position. And yes, using only hedging based strategies is a thing but I don’t want to be limited or forced to use only one kind of strategy. I am still very much into the classic way of taking a naked position and letting it either hit target or hit stop loss. So, that’s what my opinion on hedging is.

Second thing, I wrote massive blocks of texts but it seems like what really caught your attention was the part where I said that brokers should be paying penalties as well. You think I personally want that? No, I don’t want that either. Even I understand that brokers are only a medium and that additional burden should not be put on them. But it’s not like my idea or my intention behind it is entirely faulty. I believe that we can tweak my idea such that the burden of paying the penalty on the part of broker can be greatly minimised.

Now, I will be listing some changes to my original framework to benefit brokers and save them from paying penalties in the first place -

  1. If the margin shortfall is greater than 50% of the deposited margin, only then the broker pays a penalty. The client as usual would pay his penalty regardless of how small the shortfall is but the broker is liable only if he allows the position to carry forward at a loss greater than 50% of deposited margin. This would make sure that the broker follows the prudent measure of closing out the positions in case of greater than 50% loss. It’s already done at Zerodha by the way.

  2. This 50% loss threshold is against total deposited margin, not on individual positions. So, if profit in one position if netting off the loss in another, the total P/L is counted against the margin deposited for both the positions to measure for this 50% threshold. So basically, the instance of broker being liable would get reduced significantly.

  3. If the margin shortfall is less than 50% of deposited margin, then there’s no problem in letting the position getting carry forwarded. No penalty on broker. However, the broker should very much liquidate the positions on the next day if the client was unable to pay for the shortfall on the previous day and this must be done by 12 P.M. at the latest. If the broker is unable to provide for the shortfall by the said time, he would be charged a penalty on the accrued shortfall. The client on the other hand of course will be charged a penalty too as usual.

  4. To prevent rogue traders from closing one of the legs in their hedged positions without the perquisite margins for the remaining leg and thus causing trouble for the broker, the broker can very much make it so that either of the legs cannot be closed if it results in a margin shortfall. The leg can be closed only if the client has sufficient margin for the other leg.

I hope these 4 points are very much clear in getting the intended idea across and if you look at it, Zerodha and other big brokers can never be affected by this framework cause they are already prudent in their risk management. Plus, the framework is lax enough that even a small broker can easily comply with it cause the incident of the penalty being charged to the broker occurs in only 2 scenarios which the broker can easily avoid and without much hassle. I hope this is something that the world can agree on.

Tagging @nithin.