CALENDAR SPREADS IN F&O AFTER SEBI’S NEW RULES: WHAT YOU NEED TO KNOW

As a part of various measures introduced by SEBI for strengthening the Equity Derivative Framework, exchanges have recently introduced new rules for calendar spreads in the Futures and Options (F&O) segment.

These rules aim to strengthen risk management in derivatives trading and ensure market stability, particularly during volatile periods like contract expirations.

Let’s explore what these changes are, why they were introduced, and how they will impact traders.

What is a Calendar Spread?

A calendar spread in F&O trading involves taking opposite positions in contracts of the same underlying asset but with different expiry dates.

For example:

Long Position: Buying a near-month futures contract.

Short Position: Selling a far-month futures contract.

This strategy allows traders to profit from the price difference (spread) between contracts while typically enjoying reduced margin requirements due to its hedged nature.

The Old Rules:

Under the previous framework, calendar spreads were eligible for margin benefits due to their lower-risk structure.

The key features were:

1.     Reduced Margin: Margins were based on a flat percentage (e.g., 3% per month of spread on the far-month contract).

2.     Gradual Adjustment: Margins were gradually increased as the near-month contract approached expiry.

3.     Offsetting Benefit: Reduced margin requirements were applied for the combined position.

What Has Changed?

With regards to the recent circulars by NCL (NCL/CMPT/65314) & (NCL/CMPT/66047) and ICCL notice no. (20241219-27) & (20250109-60) which are effective from February 10^th, 2025, the changes are listed below:

1.     No Margin Benefits on Expiry Day: Calendar spread margin benefits will be removed entirely on the expiry day of the near-month contract and the additional margins will be required on the day before the expiry day by EOD.

2.     Higher Margins for Risk Mitigation: Positions that were previously treated as hedged will now require margins equivalent to individual, unhedged positions on the expiry day.

3.     Alignment with Other Rules: These changes align with SEBI’s cross-margin framework for correlated indices.

As per SEBI circular 5.2.4, the aforesaid would be applicable for calendar spread positions in the Equity Index Derivatives.

Additionally, from November 20^th, 2024, SEBI had introduced an Extreme Loss Margin (ELM) of 2% on short options positions during expiry days to address speculative activity observed around options positions on expiry days.

Impact on Expiry Days:

Let’s compare and understand how the implementation of these new changes will impact your positions on Expiry days. Here’s an example:

Calendar Spread - Before the Rule Change:

Pro Tip: You may use Margin Calculator to estimate your margin requirements under the new rules and avoid any last-minute surprises. Below is an example for the same:

 We can see a reduction of approx. 75% if both legs are combined which is the Hedge Benefit.

 Hence, we can see on the expiry day:

The February contract is treated as a standalone position.

The March contract is also treated separately.

No offsetting margin benefit is provided, and the trader must maintain margins for each position individually; approximately ₹4,08,487.

This increases the margin requirement significantly on the expiry day.

Extreme Loss Margin (ELM): An Additional Layer of Protection

Effective from 20^th November, 2024, the introduction of an additional 2% ELM on short options during expiry days is another critical measure. It ensures:

1.     Mitigation of Sudden Price Swings: Short options are particularly vulnerable to sharp movements on expiry days.

2.     Discouraging Over-leveraging: The ELM discourages excessive speculative activity by requiring additional margins.

Let’s understand ELM Impact for Short Options with an illustration:

 Why the Change?

SEBI identified several risks and challenges in the current system, as some of them listed below:

1.     High Volatility on Expiry Days: Expiry days see a surge in trading volumes and price volatility, exposing traders and the market to higher risks.

2.     Basis Risk: The difference in price movement between near-month and far-month contracts can increase unpredictability.

3.     Retail Investor Protection: Retail traders often leverage reduced margins to take on larger positions, which can lead to significant losses during volatile periods.

By removing margin benefits on expiry days, SEBI aims to reduce speculative trading and enhance market stability.

Impact on Traders:

1. Higher Capital Requirements: Traders will need to allocate more capital to maintain positions on expiry days, reducing the attractiveness of calendar spreads for speculative purposes.

2. Curbing Speculative Trading: The changes may deter excessive risk-taking, particularly by retail investors.

3. Re-evaluation of Strategies: Traders will need to reassess their F&O strategies and factor in the higher costs associated with expiry day positions.

Key Takeaways:

1. Higher Margins: Traders must allocate significantly more capital to hold positions on expiry days.

2. Loss of Hedge Benefit: Calendar spreads lose their cost efficiency on expiry days, making them less attractive.

3. ELM Application: The additional 2% ELM increases margin requirements further, especially for short options.

Conclusion

SEBI’s new rules for calendar spreads in F&O are a step toward enhancing market safety and protecting investors. While these changes may increase the cost of trading for certain strategies, they also reduce the risks associated with high volatility on expiry days.

Traders must adapt their strategies, stay informed, and factor with these higher margin requirements to navigate the evolving regulatory landscape effectively.

For experienced and retail traders alike, this is a reminder of the importance of disciplined risk management in derivatives trading.

To know all about SEBI’s New Rules for F&O, click here: https://www.icicidirect.com/research/equity/finace/sebi-introduces-new-rules-for-restricted-entry-in-futures-and-options-trading

Click on the link for Calendar Spread FAQs