Finance

How does Cross Margin Agreement Works?

How does Cross Margin Agreement Works?

What is Cross Margining?

  • Margin means to pay cash as collateral to cover credit risk when buying or selling futures or writing options. So when a trader wants to take a position in futures or write options, he has to deposit a certain percentage of the total exposure of contract as cash. This deposit of cash with the broker is called margin.
  • Assuming a trader wants to buy NIFTY 50 APRIL FUTURES where the total exposure is 8500 x 75 Qty = 637, 500, he has to deposit cash of roughly 63,000 (10%) as margin. Now to calculate what margin you need, NSE would calculate the net open position in every stock or index, by offsetting, for instance, futures along with options.

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  • Cross-margining, which is also known as “spread margin”, allows market participants to reduce the total margin payment required if they are taking two mutually offsetting positions.
  • In simple terms, a HDFC Bank future position at 850 (Lot size 500) could need a 20% margin, or Rs 170 x 500 = 85000 per lot. But if a trader also buys a put option on HDFC Bank at strike price say 900, then the downside is protected, so the margin requirements can be brought down substantially. The exchange will offset the two and ask for a lower margin, of say Rs. 40,000 per lot.
  • Margining offsets can also be between futures. If you’re Long April futures and Short May futures in HDFC Bank, the net margin will be considerably lesser than if a trader had either of those positions in isolation.
  • With cross margining, positions can be offset between segments. The “cash” segment – where a trader/investor owns stocks in Demat account – can now be offset against corresponding futures. For instance, Mr. K might own 250 shares of HDFC Bank. And then, Mr. K might write a call option on HDFC Bank at Rs. 900, on the basis that it won’t cross Rs. 900 this month, and he earns some premium from the position.
  • If cross-margining weren’t allowed, Mr. K would have to provide more money against the call option. This is inefficient because there is no real reason for that margin. Mr. K already owns the shares, and thus if the stock goes up beyond Rs. 900, shares can be sold to provide cash. Below 900 there is no risk to call option position (since the option will expire worthlessly).
  • Cross margining is also allowed for stocks against stock futures/options, and stocks against index futures/options. If you’re long Reliance and HDFC Bank, and short the Nifty, the stock position offsets nearly 20% of the Nifty position (as these two stocks have approx 20% weights in Nifty), so margins will be that much lesser.

How does Cross Margining Help?

  • Due to cross margining, keeping cash as the margin is substantially reduced.
  • It increases the trading capacity. Since the margin is considerably reduced, a trader can increase his position in trading with the extra margin saved due to the cross margining mechanism.
  • Certain strategies like “covered call” and “protective put” can be executed more efficiently since the trader does not have to put more cash as he is already holding stocks in the Demat account. These stocks will act as a margin and hence traders can get extra “income” by writing call/put option.

Features of a Cross Margining Agreement

  • Cross-margining benefit is available between index futures and underlying constituents/futures, stock futures, and underlying stocks; ETFs and their underlying constituents, and highly correlated indices.
  • Cross margining benefit is available to all categories of market participants.

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Cross Margin Agreement  

Cross Margin agreements can be entered between

  • Exchanges (Like NSE and BSE)
  • Clearing member and trading member
  • Member, custodian, and Constituent
  • Stockbroker and client
  1. The parties are bound by the orders, provisions, or circulars of the capital market regulator of a country (In India SEBI).
  2. The parties are also bound by the Rules, Byelaws, Regulations, and Circulars issued from time to time by clearing house(s) including provisions with respect to cross margining.
  3. The parties are subjected to terms and conditions prescribed by clearinghouse(s).
  4. In the event of default by a any of the parties in agreement, whose clients have availed cross margining benefit, clearinghouse(s) may:
  5. Hold the positions in the cross margin account till expiry in its own name.
  6. Liquidate the positions/collateral in either segment and use the proceeds to meet the default obligation in the other segment.
  7. In addition to the foregoing provisions, take such other risk containment measures or disciplinary action as it may deem fit and appropriate in this regard.

 

Author: Keval Shah

About the Author: Keval Shah is a Chartered Accountant and FRM 2 Candidate. He is passionate about financial markets and loves to play Chess.

 

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