Margins and Leverage- An Introduction

Margins and Leverage- An Introduction

Options, as we already know, are instruments for risk management, but at the same time, they can be as destructive to wipe off the entire capital of the trader. This is because options are based on premiums, about which we discussed in our previous discussions.
Options provide a huge payback in case our prediction and the subsequent trade are correct, but in case, we make a wrong trade, the entire premium amount is gone, that is, can’t be recovered. This makes options very dangerous for a retail investor. Thus, it has been decided that the Total contract value of any options contract must not be below Rs. 2 lakh. This is a guideline that has been issued by SEBI with the intention of keeping options out of the reach of small and marginal investors and traders, for the very nature of options makes them very risky and any mistake could lead to catastrophic results.
Thus, we have understood that options are risky by the very nature, but a feature that makes them exponentially more risky is that they are leveraged. As is the practice in India, and in most of the marketplaces, options and futures are traded at margin, and in addition to that, the brokerage provided leverage to the trader as well. Suppose, for example, that I am trading in the NIFTY options and the margin requirement for that option is 15%, and the contract value is Rs. 2 lakh, then I’d be required to deposit a margin of Rs. 30,000 with the exchange. And add to that the leverage that my broker provides me is 5 times the deposit, then I’d only be required to use Rs. 6,000 to trade in the NIFTY options of the value of Rs. 2 lakh. This is oversimplifying the whole mechanism to a great deal, but the essence is that we can use our money to trade in large volumes, thus opening up the possibilities of great profits, although the downside is of equal magnitude.
We will, in further discussions, study each of the aspects of margin, leverage, maintenance and call margin in detail.

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