What is SPAN and exposure margin?

Podcast Duration: 06:33

I once read a strange article in the paper about a young man who sued his bride's family because the photographs he had been sent prior to the (arranged) marriage were in dire contrast to what she looked like in real life. The man said in his statement that the law should have some safeguard against such deception. I'd actually heard a similar request before. At a travel conference, Indian travel agents urged the Thailand government to implement penalties for hotels that displayed misleading photographs of their hotel, resulting in duped and disappointed travellers.

Margins are a fairly common term when it comes to the stock market. The concept of margins brings to mind these incidents because margins are fixed by SEBI in order to safeguard stockbrokers when traders experience losses.

Brokers are expected to block margins when traders hold derivative positions overnight. Derivatives include futures and options contracts. Futures and Options contracts basically give the right or obligation to buy or sell a given security at a predetermined price, by a predetermined date.

Today we are going to delve into the concepts of Span margins and exposure margins.

The span margin is the minimum required margin as per the directives of SEBI. Span margin stands for standardized portfolio analysis of risk. Until two years ago, stock brokers were only compelled to block this margin from their traders.

The exposure margin was once optional, but as of 2018, also compulsory as per the SEBI mandate. This margin is over and above the span margin and is intended to act as a buffer against market to market losses.

The margin amount is blocked by the stockbroker at the moment when the trader initiates a futures or options trade. Traders can easily calculate the margins applicable for the F&O trade they intend to carry out on the Angel One app, quickly and free-of-cost.

If margin is not blocked, a margin penalty of up to 5% of the value of the F&O contract is applicable.

I bet you're considering what the idea of the bifurcation is, if both are compulsory and both are parked with the same party, that is, the stock broker.

The span margin is dynamic, or in other words it keeps fluctuating and is not fixed, because it is linked to the level of volatility of linked stock, commodity or currency.

Exposure margin on the other hand is a static, or fixed, amount. It stands at 3%. So if your F&0 contract size is Rs 100,000 you would need to park Rs 3,000 with your stock broker (over and above the variable span margin amount).

In case you're wondering what the great idea of blocking margins is, it is to ensure that the market and the stockbroker are protected from losses incurred by traders. It's the same funda as five star hotels deducting a deposit from your credit card, should you raid the minibar or destroy hotel property and run off. The same funda that has you leaving your pan card with the guy you rent a bike from in Goa. The very same. If a trader incurs losses and makes a run for the exit without settling his losses, the stockbroker can utilise the margins to settle the traders debts.

Span margins use algorithms and automation to assess the total one-day risk for a trader's trades or for the F&O contracts held by him. The algorithms calculate the worst possible market scenario for a single day and base margins on this potential scenario. Various conditions are taken into account. Potential earnings and/are losses are calculated taking into account three basic factors: One: time to expiration of the F&O contract (that is how close is the "predetermined date" by which the predetermined price will need to be paid. Two: price change of the security that the contract is linked to and

Three: volatility, which we have covered earlier in today's discussion.

An important point that traders must factor in while planning their trades is the fact that since span margin is dynamic, the stockbroker might call upon the stockbroker to increase his margins if volatility increases. Traders must absolutely keep aside capital for such a situation because if they are unable to do so, they might have to close some positions immediately even if the timing is not right to close those positions. This is a potentially loss-making move and as a result it is absolutely imperative that a safety net amount is retained by the broker in case he needs to scale up his margins. Of course if volatility decreases, the stockbroker will release some of the margins blocked and traders may use this as their buffer (in case margins increase again) or to increase the amount invested in F&O.

The existence of margins sort of keeps the trader's mindset very realistic when it comes to the risks of trading on the stock market. The trader is reminded of what he stands to lose and might therefore trade with more caution.

Moreover, the amount of margin is a clear indicator of how much risk the algorithm has calculated for the trade at hand. A really escalated margin amount might in itself present a red flag to a trader who prefers to play a less volatile trading game.

Many traders grumble about margins but it is honestly a good thing because it makes the stock market a marginally safer place overall.