The SEBI circular issued on October 1 made several changes to derivatives trading. Take the permitted lot size for index derivatives, which is currently set such that the contract value is between ₹5 lakh and ₹10 lakh. The revised value of the contract, which will come into effect from November 20, will be between ₹10 lakh and ₹15 lakh. This week we discuss the potential impact of contract value revisions on trading strategies.

Spreads better?

An increase in contract value will result in an increase in the permitted lot size. But most importantly, the increase in contract value will result in a higher margin requirement. Thus, the capital required to trade derivatives is likely to increase.

Will this bias cause traders to turn to spreads rather than long or short positions in single futures contracts? For example, at the time of writing, a long position in short-term Nifty futures required an initial margin of ₹70,000. But if you were to add a Nifty short out-of-the-money (OTM) call, say 25,200 in the near month, to the long forward position, your combined margin would be around ₹83,000. Certainly, your margin is higher than for a long position on simple futures contracts, but you can make greater profits depending on your view of the underlying. Suppose you expect the underlying to gradually increase until the contract expires. Let’s also assume that you expect the index to face strong resistance below 25,200. In this case, a short OTM long futures position could be profitable.

But what if your goal is to reduce margin requirements through options? Note that option margins are only charged when you initiate short positions; because long positions require you to pay an upfront premium. Suppose you want to short the near month Nifty 25,000 call. Based on current regulations, your margin would be ₹62,000. But what happens if you combine a long position on, say, the 25,500 call of the same expiration? Your margin requirement decreases by ₹42,000. But your initial output will increase by ₹3,500; the price you need to pay to buy the 25500 call. This is indeed a significant cost to save ₹42,000 in margin – a cost that most traders may not be willing to make. For what? Margin is not a cost but an outflow of funds that will be credited to your account when you close the transaction. Being long a call is a cost, and the position will lose value with each passing day due to time degradation. The above argument, although limited in scope, suggests that traders cannot be biased toward option spreads when margins increase.

Futures or options?

The choice between options and futures should not be based on margin requirements, but on your view of the underlying.

Optional reading

It is likely that many traders will turn to long options rather than long futures. But this may not be optimal because the choice between options and futures should not be based on margin requirements. Rather, it must be based on your view of the underlying; if you are confident in a breakout of the underlying, futures contracts can be more profitable despite higher margins due to their almost one-to-one movement with the underlying.

The author offers training programs for individuals to manage their personal investments