What Are Margins in the Stock Market & How Do They Work?
Several stock exchanges have incurred liquidity crises due to defaults in payment by investors. A default leads to a domino effect on the stock exchanges, which can also lead to the collapse of the entire system.
Memories of the Calcutta Stock Exchange liquidity crisis are still fresh in everybody’s mind. It happened due to large-scale defaults by investors. To avert such situations, SEBI came out with several risk management initiatives, and margins are one of them. It is a collateral or security deposit paid by an investor to brokerages while executing an order.
Let’s see some of the working aspects of margins in stock markets.
What Is the need for Margins?
As already discussed, it is a risk management measure aimed at preserving the liquidity of stock exchanges. Let’s understand the importance of margins from a short example:
Suppose Mr. X wants to purchase 100 shares of ABC Limited Company on October 31, 2022. The market value of these shares is ₹200. As a result, Mr. X must pay the broker ₹20,000 for the successful purchase of these shares on or before November 1, 2022. Brokerages will transfer the required amount to stock exchanges before November 02, 2022.
However, there is a possibility that Mr. X cannot pay the required amount. To tackle such a scenario, Mr. X must pay a token amount or advance to the stock broker while placing the buy order. This advance or token amount is known as a margin in stock markets.
Every trading transaction entails a buyer and a seller, and if the buyer does not pay up, it will be a loss to the seller. This margin covers the loss of default. The market price of shares fluctuates every minute; in case it falls at the end of a trading session, and the buyer does not show up, there will be a loss for sellers. In simple terms, the margin is the collateral that an investor deposits to a broker or stock exchange to cover the credit risk that the investor poses for the broker or the stock exchange.
What Are the Types of Margins in the Cash Segment?
First, we will discuss various types of margins in the cash segment:
- Value At Risk (VaR) Margins
It is a numerical measure of the worst possible loss that a stock can go through in one trading session. Stock exchanges use the historical volatility and turbulence associated with the respective stock to compute these margins.
Generally, it serves a good purpose unless exceptional events take place. The stock exchanges usually collect the same on an upfront basis, aiming to cover the largest loss faced by traders.
- Extreme Loss Margins
These margins can cover the potential loss outside the scope of VaR margins. In other words, any loss left behind that is not covered under VaR margins will get covered under the extreme loss margins.
Initially, it was optional for stock exchanges to collect these margins. However, after several research studies, market regulators made it mandatory for brokers to collect extreme loss margins from their clients.
These margins are computed using stock price data from the previous six months. Usually, stock exchanges fix these at the start of every month.
- Mark-to-Market Margin (MTM)
Another margin collected by brokers in the cash segment is mark-to-market margins. Unlike extreme loss margins, which remain fixed at the beginning of the month, stock exchanges calculate MTM margins on a daily basis.
After the trading session, market participants assess transaction prices to closing prices of the securities to determine mark-to-market margins. It aims to cover the loss associated with daily price movements.
Types of Margins in the Futures and Options (F&O) Segment
Now that you know the margins operating in the cash segment, let’s focus on margins in the futures and options derivatives segment. They are as follows:
- Initial Margins
This margin is computed using advanced software called Standard Portfolio Analysis of Risk (SPAN). It uses a simulation-based approach to calculate the margin value. SPAN creates various simulations by assuming different price and volatility values as both of them keep on changing.
The software arrives at several loss values, and the trader (buyer) has to pay the highest loss on an upfront basis.
- Exposure Margins
These are supplementary margins collected along with SPAN-based initial margins. It is a percentage value levied on the face value of the stock The percentage is different for futures and options. Suppose the exposure margins for index options and index futures are 5% of their notional value. For individual stock’s futures and options, the exposure margin is set at a higher percentage, i.e., 7%.
- Premium Margin
It refers to the maximum loss a trader can incur on buying options. Therefore, there can be no further margins on the corresponding buy position.
- Extreme Loss Margin for Futures and Options
These represent a percentage value that gets levied on futures and options transactions. Extreme loss margins for F&O are 2% of the notional value of index-related derivatives. Moreover, it stands at 3.5% of the notional value in the case of stock derivatives.
Brokerages must mandatorily collect these margins on the second day of the trade. Stock exchanges levy these margins when the price becomes excessively unfavourable for traders. The computation process involves comparing both the transaction price and closing price of the respective security.
- Delivery Margins
These margins are applicable for the physical delivery of equity-related derivatives. It is a margin under which any outstanding equity futures and options positions need additional margins four days before their expiry. The delivery margin gets released once the physical delivery process gets completed.
What Are Penalties for Non-Payment of Margins?
Every trader is liable to pay penalties if they cannot pay margins to respective clearing houses. These penalties or interests are levied as per regulations and by-laws. Currently, the clearing members collect 0.07% of the total default amount in case of overnight settlement shortage having a value of more ₹5 lakh.
Moreover, in the case of capital cushion shortage and security deposit shortage, the value of the penalty is 0.07% of the total default amount.
Margins in stock markets are a risk management tool that aims at protecting liquidity and maintaining the financial soundness of stock exchanges. It is the duty of brokerages to collect margins from their clients and deposit the same with the stock exchange. It is imperative that buyers deposit this advance amount for successfully placing their orders and to avoid penalties.
Frequently Asked Questions
What are peak margins?
These are the newest margins introduced by SEBI India’s capital market regulator. Under this, brokerages shall collect an upfront margin from their client in the form of securities or liquid money through margin pledging or fund transfer. They shall collect this before executing any order of their clients.
What are the penalty charges for short reporting of margin?
Traders are liable to pay the penalty for short reporting. In case of short reporting of less than ₹1 lakh and less than 10% of applicable margins, traders shall pay a penalty of 0.5% of the total order value. Moreover, if short reporting is ₹1 lakh or is 10% of the applicable margin, the applicable penalty is 1% of the order value. If short/non-collection of margins for a client continues for more than 3 consecutive days, then a penalty of 5% of the shortfall amount shall be levied for each day of continued shortfall beyond the 3rd day of the shortfall.
If short/non-collection of margins for a client takes place for more than 5 days in a month, then a penalty of 5% of the shortfall amount shall be levied for each day, during the month, beyond the 5th day of the shortfall.
What are the margin requirements in consolidated crystallised obligations of derivatives?
There are two margins in this segment – an intraday basis and end of the day basis. Intra-day basis involves closed-out futures and represents the premium payable or receivable by the client. On the other hand, the end of the day involves the obligations of clients after considering all futures and options positions.
What is the full form of SPAN?
SPAN is Standard Portfolio Analysis of Risk software that helps stock exchanges compute the margins in futures and options segments.