What are the Different Types of Margin?

What Are the Different Types of Margins?

Margin trading permits investors to purchase stocks and other financial assets by partially financing the purchase while borrowing the remaining from a broker. This approach enhances purchasing power, allowing traders to make larger investments than their available capital. However, it comes with considerable risks, including amplified losses and potential liquidation.

Traders engaging in margin trading usually have a higher risk tolerance level and aim to capitalise on short-term price movements. By leveraging borrowed funds, they seek to maximise returns based on market trends and assessment. Key benefits include higher investment capacity, portfolio diversification, and enhanced liquidation.

Maintaining the minimum account balance is important. Failure to do so may result in the broker forcibly liquidating assets. While margin trading offers opportunities, it demands a deep understanding of the risks involved and a strategic approach. A disciplined trader can take advantage of market dynamics while avoiding possible market downfalls.

What Is Margin Trading?

Margin trading refers to buying stocks or other financial assets by paying a portion of the purchase price and having the remainder funded by a broker. In simple terms, it is similar to getting a loan from the broker to acquire more assets than what can be purchased.

Let's illustrate this with an example. Assume you wish to purchase 200 shares of a company that is trading at ₹50 per share. You have only ₹5,000 in your account. You use this money to buy half, i.e., 100 shares, whereas the other half, ₹5,000, is financed by your broker.

What Are the Different Types of Margins?

Margins are important in financial markets as they reduce risks while ensuring trading activities remain stable. Margins protect traders and brokers as well as exchanges against possible losses due to price fluctuations in both the cash market and the Futures and Options (F&O) segment. Below is an analysis of the various types of margins and their significance.

Value at Risk (VAR) Margin

VAR margin is a risk management measure prepared to account for the worst possible loss scenario for a specific stock over a defined period. It is computed depending on the historical volatility of the stock. The basic objective of VAR is to figure out the potential loss that a stock could suffer under usual market conditions.

Securities and Exchange Board of India (SEBI) mandates the collection of VAR margin upfront to cover risks arising owing to market fluctuations. The calculation involves complex statistical models considering price fluctuations over a specific period. Note that stocks with high market volatility have higher VAR margins.

Extreme Loss Margin (ELM)

The ELM functions as a buffer against price fluctuations that exceed the VAR predictions. Since markets are unpredictable, ELM ensures additional risk coverage. It is based on the stock's volatility over the past six months.

ELM is determined at the start of the month and is collected in addition to the VAR margin. It is generally charged as a fixed percentage of the transaction value. Similar to VAR, ELM is even mandatory and must be deposited according to SEBI guidelines to mitigate risks owing to sudden market crashes.

Mark to Market (MTM) Margin

MTM margin is a risk management mechanism used for adjusting the value of an investor’s open positions, reflecting changes in the stock’s market price.

At the end of every trading day, if a trader has an open stock position, the price difference between the trade execution price and the day’s closing price is settled. In case the price moves against the trader’s position, they must pay the margin shortfall. In contrast, if the price moves in the favour of the trader, they receive the difference.

MTM margin is essential in the cash market, particularly when traders use margin funding. It ensures brokers do not bear the risk of losses resulting from price movements and market volatility.

Margins in the F&O Segment

Trading in the F&O segment involves complex risk management strategies. The following margin types are:

Initial Margin

Initial margin is the upfront margin that is collected before initiating a futures or options trade. It's calculated using Standard Portfolio Analysis of Risk (SPAN), a software developed by the Chicago Mercantile Exchange (CME). The SPAN simulates 16 distinct price and volatility scenarios to determine the maximum possible loss.

This margin is collected to cover the highest potential loss across scenarios. As SPAN margins are dynamic, they are recomputed multiple times a day. Higher market volatility leads to higher SPAN margin requirements.

Exposure Margin

Exposure margin is charged in addition to SPAN margin and serves as an additional cushion against market risk.

• For stock futures and short positions in stock options, the exposure margin is higher by 5 percent of the notional value or 1.5 times the standard deviation of the logarithmic returns of the underlying stock over the past six months.

• For index futures and short positions in index options, the exposure margin is 3 percent of the notional value.

This margin is prepared to mitigate risks arising from price fluctuations beyond SPAN predictions.

Premium Margin (for Option Buyers)

When purchasing an options contract, traders must pay a premium. The premium margin is computed as:

**Premium margin = Premium value x number of options bought **

This amount represents the maximum potential loss for an option buyer, and it is collected at the scenario of trade execution. As options buyers cannot lose more than the premium paid, they do not require maintaining additional margins.

Assignment Margin (for Options Sellers)

Options sellers (or writers) are exposed to unlimited risk, unlike options buyers. When an option is exercised, the seller must fulfill the contract obligation, leading to potential losses.

Assignment margin is charged when an option is exercised and is calculated based on the net exercise settlement value due from the seller. It ensures that option writers have sufficient funds to meet their obligations.

Extreme Loss Margin (ELM) for Derivatives

Similar to the cash market, derivatives contracts also require an ELM.

• For index derivatives, the ELM is 2% of the notional value.
• For stock derivatives, the ELM is 3.5% of the notional value.

This margin provides a safety net against unexpected market events, ensuring traders and exchanges are protected against extreme market fluctuations.

Mark to Market (MTM) Margin in F&O

Mark to market (MTM) margin is applicable to futures contracts and certain options positions. At the end of each trading day, all open positions are revalued based on the closing price. The difference between the contract price and the closing price is either credited or debited to the trader’s account.

For futures traders, MTM adjustments ensure that losses are accounted for daily, preventing the accumulation of large unpaid losses. It is similar to MTM in the cash market but applies over multiple days instead of just intraday positions.

Delivery Margin

Delivery margin is a requirement in equity derivatives trading. If a trader holds a contract until expiry and the contract results in the actual delivery of shares, an additional delivery margin is imposed.

• This margin is blocked four days before contract expiry.
• It remains in place until the settlement process is complete.

The purpose of this margin is to ensure that the trader can meet the financial obligation upon contract expiration.

Peak Margin Requirement

Introduced in 2020, the peak margin framework became fully applicable in September 2021. It was implemented to prevent excessive leverage in intraday trading and ensure brokers and traders maintain sufficient funds before executing trades.

Under peak margin rules:

• A trader must maintain 100% of the peak margin (VAR + ELM) before placing a trade.
• The exchange captures four position snapshots per day and considers the highest margin requirement from these snapshots.
• Any shortfall in maintaining peak margin results in penalties imposed by SEBI.

The peak margin rule aims to protect traders from excessive leverage risks and prevent sudden liquidity crises in the market.

Who Are Margin Traders?

Before getting into the nitty-gritty of margin trading, let’s understand a bit about margin traders who indulge in this form of trading. Margin traders are individuals who seek to make quick profits from price movement of security by leveraging funds beyond their current financial capacity. They don’t want to avoid missing trading opportunities due to limited funds and use margin trading as leverage to increase their trade size.

Generally, margin traders have a higher risk tolerance and a deep understanding of financial markets. They analyse [market trends] (https://www.kotaksecurities.com/investing-guide/share-market/understanding-stock-market-trends/), study price movements, and stay informed about various indicators to make informed trading decisions.

Benefits of Margin Trading Facility

Now that you know what margin trading is, let’s look at some of the benefits it brings to the table. Margin trading offers you the following advantages:

Enhanced Buying Power

This is the most apparent benefit of margin trading. It enhances your buying power by several notches with extra funds available in your account. With it, you can expand your investments by acquiring more shares or other financial instruments than your available capital alone would permit. This boosted buying power can significantly enhance your profits.

For instance, the [margin trading facility] (https://www.kotaksecurities.com/margin-trading-facility/) from Kotak Securities gives you 4X buying power and allows you 4 times the leverage on 1000+ stocks and [exchange-traded funds] (https://www.kotaksecurities.com/investing-guide/equity/exchange-traded-funds/) (ETFs). With a margin trading facility, you can effectively amplify your investment opportunities. It frees you from the shackles of limited funds and allows you to tap into a broader array of financial assets, thus increasing your profit potential.

Diversification Opportunities

Diversification is one of the fundamental investing principles. It helps in effective risk mitigation. With margin trading, you can invest in various stocks across industry verticals. Also, you can add other financial assets to your investment portfolio. All of these go a long way in helping you diversify your portfolio and bring down risks.

Liquidity and Quick Decision Making

With margin trading, you get enhanced liquidity. This empowers you to grab market opportunities and benefit from short-term price fluctuations. This can be a game-changer if you are looking to capitalise on rapidly changing market conditions and execute timely buy or sell orders.

Risks Associated with Margin Trading

While margin trading has its share of advantages, it has its own risks. Some of the common risks associated with it are as follows:

Amplify Losses

While margin trading can boost your profits, it can also amplify your losses. If your investments fail to perform and plummet, you might make huge losses. Note that you need to pay interest on the margin money. If you suffer losses, your principal amount can get eroded, and the interest you pay on margin money can further pinch you hard.

Risk of Liquidation

This is another potential risk of margin trading. Note that you need to maintain a minimum balance in your trading account. If your balance drops below the minimum, your broker will ask you to maintain balance. If you fail to do so, you might need to sell some or all assets to meet the minimum balance requirement. That’s not all. Brokers can initiate action against you if you fail to honor the terms and conditions of the margin trade agreement. In that case, your broker can liquidate your assets to recover the money lent.

Summing It Up

As evident, if done right, margin trading can potentially boost returns. That said, it is equally essential to be aware of its risks. A clear understanding of how it works and its prudent usage of the funds acquired from your broker can help you make the most out of this facility. Happy investing!