When you buy or sell stocks in the cash segment, the stock exchange collects a token amount from the broker called margin. The broker collects this money from you and deposits it with the exchange. Today, we are going to talk about margins in the cash market and understand the various components that constitute the margin amount.
Uncertainties are breeding grounds for risks. For example, the more uncertain the road conditions are, the higher the risk of an accident. Similarly, in the stock markets, uncertainty in the movement of stock prices leads to risks. To counter these risks, stock exchanges use the margining system.
In the stock market, there is a buyer for every seller. Hence, if the buyer does not bring any money to a particular trade, the seller does not get paid for his/her shares. On the other hand, if the seller does not provide the shares, then the buyer doesn’t receive shares that he/she has paid for.
Let’s say that you purchase 1000 shares of a company at Rs.100 per share on Monday (T day). The broker has to ensure that he gives Rs.100000 (1000×100) to the stock exchange on the T+2 day.
Many brokers allow their clients to pay the amount for the shares purchased on T+1 day. However, there is a risk that you might not be able to pay the required amount to the broker on T+1 day. Hence, the stock exchange asks brokers to collect a minimum percentage of the purchase amount or margin at the time of placing the order and deposit it with the exchange. This amount is called margin. While some brokers collect only the margin amount, others collect the entire purchase amount from the investor at the time of purchase.
So, in the above example, if the margin decided by the stock exchange was 30%, then Rs.30,000 would be the mandated margin. Hence, that is the minimum amount that a buyer needs to pay to buy the said shares.
When you buy or sell in the market, you expect the trade to be fulfilled regardless of the change in stock price.
After you purchase the above-mentioned shares on T day, you receive delivery of the said shares on T+2 day. Let’s say that on T+1 day, the price of the shares increases to Rs.125 per share. Hence, before you receive the shares, you are already making profits.
While this is good news for you, the seller might not be comfortable selling shares for Rs.100 while the market price has increased. On the other hand, if the price of the share falls to Rs.75, then you might not be keen on fulfilling your purchase order at Rs.100 per share.
In both these scenarios, the margining system helps ensure that both buyers and sellers fulfill their obligations.
The stock market has various types of instruments being traded regularly. Hence, a single margin for all shares might not be able to handle the risk. Broadly, retail transactions can be categorized into cash market and derivatives market transactions. So, SEBI has prescribed different ways to approach the margin calculation for cash and derivative segments. Today, we will be looking at the cash segment.
Among the different types of margins in the cash segment, there are three main types that we will be discussing.
Let’s look at each of them separately:
VAR margin is the primary margin in the cash market segment.
While we know that the historical volatility of stock can tell us how the security price moved in the past, when we buy or sell the stock it is important to know how much it is likely to move in the next day. VAR is a statistical method of determining the probability of loss of value of a stock by using historical volatility and price trends.
A VAR statistic has three parts:
Here is an example:
Let’s say that you buy shares of HDFC Bank today. The market value of your investment is Rs.10 lakh. Obviously, you don’t know what its price will be tomorrow. By using VAR methodology, let’s say that you find that the VAR for one day at a 99% confidence level is Rs.1 lakh. This means that under normal conditions, the value of your shares will not fall by more than Rs.1 lakh during the next day.
Now that you understand the concept of VAR, let’s apply it to a stock exchange. When an investor purchases or sells a stock, the exchange calculates his maximum possible loss in one day using VAR with a 99% confidence level. Once the exchange knows this amount, it charges it upfront to the investor as margin so that if the investor does not honor the trade, then the loss is recovered.
While VAR covers the largest loss that can be encountered on 99% of the days, Extreme Loss Margin or ELM covers losses beyond the expected loss situations covered under VAR calculation. Think of this as a second line of defense to cover potential losses. The ELM of a stock depends on the risk associated with it. The exchange determines ELM of a particular stock at the end of each month by considering the stock price movement over the previous six months.
The third type of margin collected from an investor is the Mark to Market or MTM margin. This is calculated on all open positions of an investor on any trading day. The transaction price and the closing price of the share are compared. If the closing price is less than the transaction price, then the investor faces a notional loss that needs to be paid to the exchange.
For example, let’s say that you purchase 1000 shares of a company at Rs.100 per share on Monday (T day) at 11 am. At the end of the trading day, the price of the share falls to Rs.80. Therefore, you will face a notional loss of Rs.20,000 on your buy position. This is called MTM loss and the broker collects it from you before the start of the next trading day.
These three margins are collected from the investor in the cash segment. Remember, margin collection is the method followed by the stock exchange as a part of its risk management policy. It helps protect genuine investors from scammers and trade confidently.
Hope this was helpful.