Case 013Margin, clearing and risk limitsCore
A client with Rs 5 lakh sells two lots of out-of-the-money index calls at Rs 1.4 lakh margin a lot. A volatility spike and a rally raise margin to Rs 3.1 lakh a lot and the calls lose Rs 60,000. What happens, and what are the client's choices?
1The situation
A client of Bhorghat Broking has Rs 5 lakh in the trading account and sells two lots of Satpura 50 calls struck 4% above the market, collecting Rs 150 a unit, Rs 7,500 a lot, Rs 15,000 in all. The exchange margin at the time of the trade is Rs 1.4 lakh a lot, Rs 2.8 lakh for the position, leaving Rs 2.2 lakh free.
Two days later a sharp rally lifts the index 3% and implied volatility jumps. The margin requirement rises to Rs 3.1 lakh a lot and the calls are marked Rs 60,000 against the client. The broker's rule is that shortfalls must be cleared by the next morning or positions are squared off.
2Your task
Show the account before and after, compute the shortfall, and lay out the client's choices with the cost of each.
Quick check
Before the arithmetic: the index is still below the strike, so the calls are out of the money. Can the client still face a margin call?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The account falls to Rs 4.4 lakh of equity while margin required rises to Rs 6.2 lakh: a shortfall of Rs 1.8 lakh. Before the move the client had Rs 2.2 lakh spare; after it, the loss and the margin rise land together. The choices are to deposit at least Rs 1.8 lakh, close one lot and realise half the loss, which brings required margin to Rs 3.1 lakh, or close both. Doing nothing means the broker squares off at the open, possibly at a worse price and with a penalty.
Step 1What does the account look like before and after?
Keep two numbers side by side: what the account is worth, and what the exchange demands be held against the position. On trade day the equity is Rs 5.0 lakh and the requirement Rs 2.8 lakh, so the client has Rs 2.2 lakh of headroom; after the rally the equity is Rs 4.4 lakh and the requirement Rs 6.2 lakh, so the client is Rs 1.8 lakh short. A tenant whose rent doubles in the same month a pay cut arrives is in the same position. The initial marginThe collateral an exchange requires against a derivatives position, set from an estimate of the loss the position could suffer over a short horizon and raised when volatility or the position risk rises. rose because the exchange's model now sees a larger possible loss on a short call that is closer to the money in a more volatile market, and the Rs 60,000 is the mark-to-market on top of that.
| Rs lakh | Trade day | After the move |
|---|---|---|
| Cash and premium in the account | 5.00 | 5.00 |
| Mark-to-market on the calls | 0.00 | -0.60 |
| Equity | 5.00 | 4.40 |
| Margin required, two lots | 2.80 | 6.20 |
| Headroom or shortfall | +2.20 | -1.80 |
Step 2What can the client do, and what does each choice cost?
Three real choices and one default. Deposit Rs 1.8 lakh or more by the morning and keep the position; the view that the calls will expire worthless is intact, but the client is now committing Rs 6.2 lakh of margin to earn Rs 15,000 of premium. Close one lot at the market: that realises Rs 30,000 of the loss, leaves equity at Rs 4.4 lakh against a requirement of Rs 3.1 lakh, and restores Rs 1.3 lakh of headroom. Close both: the Rs 60,000 loss is final and the client walks away with Rs 4.4 lakh. The default is to do nothing, in which case the broker squares off at the open; if the rally continues overnight the squared-off price is worse, and a shortfall that is not met can attract a penalty passed on from the exchange.
Step 3Why is this the lesson about selling options?
The client collected Rs 15,000 and is being asked for Rs 180,000 two days later. A short option's loss and its margin rise arrive together, because the same move that costs money is the move that makes the exchange nervous, so the client can be forced out at exactly the moment the position is most expensive to close, even if the index later falls back and the calls expire worthless. Say the limits of the working: margin figures are illustrative and the real requirement comes from the exchange's risk model, which the client should check daily; the premium received does count as equity but is already in the Rs 5 lakh here; and the broker may hold a buffer above the exchange minimum, which makes the call larger still.
Where candidates lose it
Candidates compute only the Rs 60,000 loss and report that the client still has Rs 4.4 lakh, comfortably above the original Rs 2.8 lakh margin. The margin is not fixed; it rose to Rs 6.2 lakh, and the shortfall is the whole question.
The second loss is advising the client to hold because the calls are still out of the money. The right answer lays out the cost of each choice and names the default: a position that cannot be funded by morning is closed by someone else, at their price.
What the interviewer asks next
- The client deposits Rs 2 lakh and the index falls 2% the next day with volatility easing. What is the account now, and does the margin come back down?
- How would buying a further out-of-the-money call against each sold call have changed the margin on trade day?
- Why do exchanges raise margins during a volatility spike rather than keeping them fixed, and who does that protect?
- If the client had sold puts instead and the market had fallen 3%, which number would have moved more, the mark or the margin?
Company names and figures are illustrative.