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Nitty Gritties of Margin Calculations
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Even on a regular day, we come across a lot of ambiguity about how the weather will be or how the traffic on your way to an important meeting will be like. Despite knowing that there are uncertainties in our day-to-day life, we take the calculated measures and reach our goals.
Similarly, the stock market is also full of uncertainties when it comes to the movement of share prices.
The margining system takes uncertainty in the stock market, which can lead to risk care.
Let us understand this with an example- let us say that Rajesh wants to invest in 2000 shares of company-XYZ ltd. The value of the share is at Rs. 200 on January 1, 2019. He has to give the broker an amount of Rs. 2,00,000 on or before January 2, 2019. And the broker would have to give that money to the stock exchange by January 2, 2019.
Now there is a chance that he might not be able to bring the money which is required on the given date. As an investor to buy the shares, Rajesh has to give a certain percentage of Rupees two lacs when he's placing the order. The broker will have to pay the same amount to the Stock Exchange in return for placing the order. This initial payment is called the margin.
Margin is the money which ensures that the broker gives the buyer the promised shares and also pays the money to the Stock Exchange for the shares.
Let us consider Rajesh's example again and assume that the margin is 15%. Now Rajesh has to give rupees 30,000 to the broker for buying the shares. In this case, Rajesh purchased the shares on January 1, 2019. The price of shares falls by the end of the day by Rs. 50. Therefore the total value of the share after the decrease is Rs. _____. The loss which Rajesh has incurred is of Rs _____.
In the above example, assume that margin was 15%. That is, the investor has to give Rs.15,000/-(15% of Rs.1,00,000/) to the broker before buying. Now suppose that investor bought the shares at 11 am on January 1, 2008. Assume that by the end of the day the price of the share falls by Rs.25/-. That is the total value of the shares has come down to Rs.75,000/. That buyer has suffered a notional loss of Rs.25,000/-. In our example buyer has paid Rs.15,000/- as margin but the notional loss, because of fall in price, is Rs.25,000/-. That is notional loss is more than the margin given.
In such a situation, the buyer may not want to pay Rs.1,00,000/ - for the shares whose value has come down to Rs.75,000/-. Similarly, if the price has gone up by Rs.25/-, the seller may not want to give the shares at Rs.1,00,000/-. To ensure that both buyers and sellers fulfill their obligations irrespective of price movements, notional losses also need to be collected.
The prices of shares vary and keep moving. They are never constant. In such a situation, margins make sure that the buyer is bringing more money, and the selling is bringing in the share to complete the transaction even though the price fluctuates.
There are two types of margins which are levied in the Futures and Options segment:
1) Initial Margin
2) Exposure margin
In the case of options contracts, the following additional margins are collected along with the initial and exposure margin.
1) Premium Margin
2) Assignment Margin
How can you calculate the Initial Margin?
Based on a portfolio (a collection of futures and option positions) approach, the initial margin for the F&O segment is calculated. SPAN (Standard Portfolio Analysis of Risk) is the software which was developed by Chicago Mercantile Exchange (CME) and is used to calculate the initial margin.
A scenario-based approach is used in SPAN to calculate the margins. SPAN calculates the margin by generating a range of scenarios. To calculate the initial margin, we use the highest loss scenario. There is a need to monitor and collect the margin at the time of placing the buy/sell order. The margins calculated by SPAN are revised six times in a day. Once when the day begins, four times during the hours of the market and finally at the end of the day. Higher the volatility, the higher the margins.
How can we calculate the exposure margin?
Exposure margin is also collected along with the initial / SPAN® margin. With regards to index futures and index option sell positions, exposure margin has been specified as 3% of the notional value.
The exposure margin is 5% or 1.5 standard deviations of the LN returns of the security for the following:
Futures on individual securities
Sell positions in options on individual securities.
How can we calculate the Premium and Assignment margins?
Premium Margin is also charged to trading members trading in Option contracts similar to addition to Initial Margin. A buyer has to pay the premium margin of the Options contracts, which are equal to the options premium’s value multiplied by the number of options purchased.
Let us understand this with an example- if 2000 call options on Mega Ltd are purchased at Rs. 10/-. The investor does not have other positions; then, the premium margin is Rs. 20,000. This is to be paid at the time trade. And the assignment margin is collected on assignment from the sellers of the contracts.
So far, we have understood what margin trading is. Now let us understand some of its benefits.
- Best suited for short term generation of profit- The investors who do not have enough cash in hand and want to invest must employ margin trading. It is best suited for those investors who are looking to make a profit from short term price fluctuation in the stock market.
- Leverage the position of the market- When the investors are not from the derivative sector, they can leverage their position in securities by this trading process.
- Experience maximum returns- As an investor, you can enjoy a maximum rate of return on the capital you invest.
- Use securities as collateral- As an investor, you can use the securities in your Demat account, or you can also use the investment portfolio as collateral for margin trading.
- Regulated by SEBI- SEBI regularly supervises the facility of margin trade making it safe and transparent for both traders and investors.
Having discussed the risks, we must also look at some risks which are involved in margin trading so that you get complete knowledge from this chapter. As a wise investor, you must understand that there is a high risk associated with margin trading. There can be situations where you end up losing more than your investment. Following are important points which you need to take care of:
Minimum balance maintenance – As an investor, you will have to maintain a minimum balance in your MTF account at all times. In case the balance of your MTF account falls below the mandatory requirement set by the broker then you will either have to deposit more cash or sell off some of the stocks for maintaining the minimum balance.
Risks of liquidation – In case you are unable to uphold your end of the margin trade agreement, then the broker has the right to liquidate assets from your MTF to recover their losses.
Investment through margin trading is similar to borrowing an advance, and as an investor, you will have to pay a certain percentage of interest on it. As an investor, you need to settle the margins in time so that they don’t accumulate a considerable interest for you to pay.
You must refrain from borrowing the maximum amount allowed. What you should do is to continue margin trading once you are confident about making profits. Margin trading involves equally high risk and profits; you must be prepared to meet unfavourable circumstances with sufficient cash to complete the margins.
A quick recap
- Margin is the money which ensures that the broker gives the buyer the promised shares and also pays the money to the Stock Exchange for the shares.
- The prices of shares vary and keep moving. Margins make sure that the buyer is bringing more money, and the selling is bringing in the shares to complete the transaction even though the price fluctuates.
- SPAN (Standard Portfolio Analysis of Risk) is the software which was developed by Chicago Mercantile Exchange (CME) and is used to calculate the initial margin.
- As an investor, you will have to maintain a minimum balance in your MTF account at all times. There’s a risk of liquidation in margin trading which you will have to keep in mind.
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