Option Premium

An Option premium is money required to be paid by the option buyer to the option seller/writer. Against the payment of premium, the option buyer buys the right to exercise his desire to buy (or sell in case of put options) the asset at the strike price upon expiry.

But In India, options are cash-settled. Suppose Bonny buys Ashok Leyland July 100CE at 1 from Vinod which means it (the option contract) will expire on 27th July (last Thursday of July).

Now on the very date of 27th July, the price of the underlying (here, Ashok Leyland) is less than 100. Lot size of Ashok Leyland Options is 8000. Now, Bonny has to give 8000 INR ( =8000*1 ) to Vinod. Though Bonny has the right to exercise his desire to buy the asset at the strike price upon expiry. He can not have the asset (here, the asset is Ashok Leyland). One has to settle the difference in cash.
Sometimes, settlement happens too. I saw barrels of crude oil delivery. Now you have to pay the net asset price. (Like Delivery of 8000 shares of Ashok Leyland – Do the math). But Bonny’s max loss is limited to his premium of 8000 INR here. So, Vinod’s max profit is limited too to the premium of 8000 INR.

Nifty 50 price

The current Nifty 50 index’ spot price is 9520.9

The CMP (current market price) of NIFTY July 9600 CE is 69.45. NIFTY July 9600 CE signifies the contract which asserts NIFTY will close above 9600 at the time of closing of the market on 27th July.

Those who agree will buy this contract and will be noted as an option buyer.

Those who disagree will sell this contract and will be noted as an option seller/writer.

Premium is the money required to be paid by the option buyer to the option seller/writer.

Nifty options have a lot size of 75. Lot sizes are pre-defined. Here the premium is 75*69.45 = 5208.75 ~ 5209

When the contract is executed, an option buyer pays this money to the option writer.

To buy an option, one has to pay the premium only; there is no margin needed as the option’s buyer’s maximum loss is limited towards the premium he/she pays. But it is needed to ensure that he has the margin enough to pay the premium after the trade is executed.

To sell an option, one has to pay the margin. Once the trade is executed; his/her margin will be credited by the premium.

option premium

To sell NIFTY July 9600 CE we need a margin of 48,871 INR. Once our trade is executed, 5,209 INR will be credited to our available margin.

However, if the broker is bad, he can amend his own rules to block the premium receivable. The margin is blocked by exchanges. But the premium comes immediately directly from the option buyer immediately.

So it doesn’t mean that it needs 48,871 – 5,209 = 43,662 to execute the trade. It will need the whole 48,871 INR first and then you will be credited 5,209 INR.

Suppose you have 48,000 INR as available margin; you can not execute this trade.

Suppose you have 48,872 INR as available margin you can execute this trade and instead of having (48,872 – 48,871) 1 INR as margin you will have (5,209 + 1) 5,210 INR as margin using which you can do any trades as you wish –

  1. You can buy another option whose premium is less than 5,210 INR.
  2. You can buy/sell futures if your margin allows.
  3. You can buy some shares for delivery.
  4. You can sell other options.

You can just simply use it as a normal margin.

Ok, now you can tell to buy 9600 CE we need a margin of 5,209 INR. Practically, yes but it is theoretically wrong. The margin needed is zero. But you need to keep 5,209 INR minimum in the margin so that it can be debited. Please keep the concepts clear, otherwise, it will be a headache to understand other advanced option setups.

Span Margin

At the time of initiating trades on the stock and commodity exchanges in India, exchanges usually block margins. These margins comprise of 2 components which include SPAN margins and Exposure margins.

SPAN margin derives its origin from SPAN i.e. Standard Portfolio Analysis of Risk which is a method for measuring portfolio risk. In Indian stock markets, SPAN margin is also commonly referred to as VaR margin or initial margin which is the minimum margin requirement for initiating a trade in the markets.

The SPAN margin is usually different for every security depending on the nature of risk (volatility) of the security.

For instance, the SPAN margin requirement for an Index will be lower than the SPAN margin requirement for a single stock since the risk of portfolio/index is usually lower than that of a specific stock or security. One of the other significant factors under consideration for the determination of SPAN margins is the historic volatility of the underlying.

The lower the volatility, lower the SPAN and higher the volatility, the higher the SPAN margin requirement. If you want to read further, you can see here – https://www.nseindia.com/products/content/derivatives/equities/margins.htm

Exposure Margin

In addition to SPAN margin which is collected at the time of initiating trades, an additional margin over and above the SPAN margin is collected which is known as the Exposure margin and is also known as additional margin.

This margin is collected in order to protect a broker’s liability which may arise due to wild swings/moves in the markets.

Total Margin = SPAN Margin + Exposure Margin – Spread Benefit

  • The SPAN margin for particular security keeps changing from time to time-based on the volatility of the underlying.
  • The Exposure margin usually remains the same since its basic function is work as an additional safety net.
  • Exposure margin doesn’t have the same value as SPAN margin.
  • Spread Benefit will be discussed later on.

In the below example you can see the exposure margin remains similar for different strike prices of options of the same underlying (here, it’s NIFTY) –
Exposure Margin

Why someone will want to know how much margin is needed? What’s the benefit there?

Let’s see the margin needed for selling 9600 CE which is OTM as our NIFTY’s spot price is 9520.9

nifty margin

This is the margin needed in Zerodha.

zerodha margin

This is the margin needed in Upstox. Now let’s construct a bull spread on Upstox and Zerodha both. We shall do this using selling 9600 CE and buying 9400 CE.

bull spread

When we are going to sell Nifty 9600 CE Zerodha is taking 49,233 INR as margin and Upstox takes 48,1138.75 INR as margin.

zerodha

But we are selling Nifty 9600 CE and buying Nifty 9400CE; constructing a bull spread; Zerodha is taking 35,234 INR whereas Upstox is taking 43,050 INR.

Different broker has different benefits.

Those who hedge for them Zerodha is better; those who don’t Upstox is better.

Q. Sorry I didn’t understand, why it is theoretically wrong? If the options margin gets debited from buyer’s account immediately, then why are we calling that required margin is zero as you can’t execute the trade until you pay the full premium?

A. Now suppose you have a NIFTY 9600 CE sell. You won’t need any margin at all while buying NIFTY 9400 CE. In fact, you get more margin back.

Q. So in total when we sell 9600 CE we get the premium which we then use to buy 9400 CE? Is this how we save 10000 INR?

A. We’re getting the premium of 9600 CE anyways with or without buying 9400 CE. We’re saving additional money around 7,816 INR as margin in Zerodha.

Let’s do maths –

Selling 9600 CE takes 49,233 INR as margin and gives 5,209 INR as premium, Net margin consumed (don’t use the word needed as net margin needed is 49,233 INR) = 44,024 INR

Net Margin needed (You don’t get premium here as your premium receivable is used towards your payment of premium for 9400 CE) = 35,234 INR

Theoretically, you get the premium but it is immediately used to pay the premium you are supposed to pay to the option seller who is selling 9400 CE (as you are a buyer here).

Net Benefit = 44,024 – 35,234 = 8,790 INR actually.

Suppose, we have a 9600 CE sell. Now you get a short term intraday opportunity where NIFTY may spike up.

You can buy 9400 CE, 9500 CE without having margin now.

Not only that, you will get the additional margin. Now, we have added 9400 CE, 9500 CE buy now with 9600 CE sell.

options

Q. Thanks for explaining. I never noticed it earlier. So, when we sell an option because of portfolio & risk we have to pay “Initial” & “Exposure margin”. However, when we are buying other options, our overall risk for portfolio & exposure with the broker reduces, hence, we get the benefit of Margin. Is it right?

A. Yes, bro but it also depends on broker too. Upstox doesn’t give any margin. We will calculate the margin benefits part later until then just know that there is this benefit.

Selling 9600 CE takes 49,233 INR as margin and gives 5,209 INR as premium,

Net margin consumed (don’t use the word needed as net margin needed is 49,233 INR) = 44,024 INR

Current CMP of Nifty July 9400 CE is 186.65

To buy 9400 CE we need to pay the premium of (75*186.65) = 13998.75 INR ~ 13999 INR

So if we take these two trades of selling 9600 CE and buying 9400 CE separately, our net margin to be consumed is 44,024 +13,999 = 58,023 INR
strike price

Instead of 58,023 INR, Zerodha is taking 35,234 INR

Similarly, Upstox is giving us Margin Benefits too. But Margin benefits depend on the broker’s policy. There is no certain rule that how much the amount will be exactly.

payoff
So How Zerodha is calculating it –

Net applicable margin on Selling 9600 CE = Margin of 9600 CE – Premium of 9600 CE = 49,233 INR – 5,209 INR

Net applicable margin on Buying 9400 CE = Premium of 9400 CE = 13999 INR

Net applicable margin on (Selling 9600 CE + Buying 9400 CE)

= Margin of 9600 CE – Maximum of (Premium of 9600 CE, Premium of 9400 CE)

= 49,233 INR – 13999 INR

= 35,234 INR

margin

So How Zerodha is calculating it –

Net applicable margin on Selling 9600 CE = Margin of 9600 CE – Premium of 9600 CE = 49,233 INR – 5,209 INR

Net applicable margin on Buying 9400 CE = Premium of 9400 CE = 13999 INR

Net applicable margin on Buying 9500 CE = Premium of 9500 CE = 117.5*75 INR = 8812.5 INR (CMP of 9500 CE is 117.5)

Net applicable margin on (Selling 9600 CE + Buying 9400 CE + Buying 9500 CE)

= Margin of 9600 CE – Maximum of (Premium of 9600 CE, Premium of 9400 CE, Premium of 9500 CE) – 2nd Maximum of (Premium of 9600 CE, Premium of 9400 CE, Premium of 9500 CE)

= 49,233 INR – 13,999 INR – 8812.5 INR

= 26736.5

What is important is the concept of margin benefit. Your calculation may not match with mine because of the CMP of 9600 CE, 9500 CE, 9400 CE will vary due to our sources.

But here is the concept.

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