What are the Different types of Margins
In this segment, we look at the types of margins that are levied on cash and futures and options positions. There are various margin types ranging from initial margins to MTM margins, which you must be familiar with. These margin types also vary from one product to another. While understanding the different types of margins, it is important to first understand the concept of margins and the reason it is levied.
Remember that the different types of margins are a risk management measure and are based on a worst-case assessment. If the exchange does not have enough margins and the client defaults, then it creates a cyclical reaction in the entire system. To avoid such an eventuality, the different types of margins are levied on the trader. These different types of margins are applicable on the buy-side and sell-side of equity and derivative trades.
Different types of margins
Those of you who have been in the stock markets since 2000, would recollect the payment crisis at the Kolkata Stock Exchange in 2001 when the exchange came to the brink of default. Those were the days when margin rules were not so stringent and risk management was done a lot more on an ad-hoc basis. Today margining is a complete focused activity and monitoring of risks and exposures as well as client margins is at a real-time level. That is what makes the current margin system so effective.
In this segment we look at the different types of margins in the stock market; both in the cash segment and the F&O segment. The customer has to mandatorily deposit a certain amount of money with the broker to buy or sell stocks on the exchange. The margin is the name given to this amount of money, which almost serves as a caution deposit. The extent and amount of margin required to be paid by traders are determined by the exchange based on factors like volatility of the stock and other risk factors.
The logic of charging margins in equity trades
Let us understand the logic of margins with an example. Say, a trader buys 100 shares of Reliance Industries, it would cost him nearly Rs.210,000 to be paid. If the stock price goes up, there is not much to worry about, but what if the price falls by 10% on the same day. Now after the stock has fallen 10% if the client has enough money to pay margins, there are no issues. However, if he defaults on the money, then there is a 10% loss on the position. The margin is collected from the customer to cover this type of loss. Normally, margins are collected to cover the maximum possible loss on a single day in a worst-case scenario.
Here is a quick look at the different types of margins in the cash market
Broadly, the margins in the cash market can be divided into the following categories.
The first and perhaps the most important type of margin is the Value at Risk or VAR margin. This VAR is a statistical measure and it measures the worst-case loss estimate on a stock in a day, based on the historical volatility of the stock. This method is statistical but it serves a good purpose unless there is a Black Swan event.
The second type of margin in the cash market is the Extreme Loss Margin or the ELM. The purpose of the extreme loss margin or ELM is to cover the losses that could occur outside the coverage of VAR margins. In the past, this was not mandatory to collect. However, now SEBI has made it mandatory for brokers and trading members to collect both the VAR and ELM from the client upfront.
Mark to Market margins or MTM margins is also charged by the broker for cash market clients where there is a margin trading facility to cover the additional risk of daily price movements.
SEBI has recently introduced the Peak Margin system in phases and it would be instructive to even understand the peak margining system in greater detail. As per the latest guidelines issued by SEBI, brokers must collect upfront margins in the form of funds or securities by way of Fund transfer or Margin Pledge before executing any transactions on behalf of the clients. In short, brokers must restrict themselves from providing additional leverage over and above what VAR+ELM.
This system was introduced in a phased manner and effective July 01, 2021, the exchange has entirely moved towards a peak margin system to the tune of 100%. Under peak margin reporting, Exchange sends 4 Snapshots in a day on a scheduled time (random process). At the end of the day, Exchange will consider the maximum margin across that 4 snapshots / Margin files for any client which will be considered Peak Margin.
Margin in derivatives segments
Having seen margins on the equity segment, let us now turn to margins on futures and options. Here is a quick summary of margins on the F&O space.
First is the initial margin on F&O, which is based on SPAN, which is similar in concept to VAR. Here SPAN stands for Standard Portfolio Analysis of Risk. These SPAN margins are revised 6 times a day. The higher the volatility, the higher will be the SPAN margins.
The second is the Exposure Margin, which is an adjunct and is collected in addition to the SPAN margins. These are fixed percentages. For example, currently, the exposure margins on index futures and index options are 3% of the notional value. For futures on individual securities and sell positions in stock options, the exposure margin is fixed at the higher of 5% or 1.5 standard deviations of the lognormal returns of the security; over six months period.
In addition, option buyers also pay Premium Margin, which is the maximum loss on the buy options position, so there is no further margin on that position.
In addition, extreme loss margins or ELM for options and futures contracts are calculated at 2% of notional value for index derivatives and 3.5% of notional value for stock derivatives.
A very important margin that is collected from the second day of the trade is the mark to market or MTM margin. That is applicable when price movement is unfavorable to the trader. MTM losses are calculated by marking each transaction in security to the closing price and are mandatorily collected before the start of trading the next day.
Last, but not least, there are delivery margins for physical settlement in equity derivatives, which is a recent addition. Under the new system, any outstanding position in equity futures and equity options require additional margins to be blocked on the last 4 days before expiry. The delivery margin would be released automatically once the physical settlement process is completed.
Interest and penalty on margins
Investors not able to provide the securities at the time of settlement are obligated to pay the penalty charges to the clearing member. The penal charge is levied on the amount in default as per the bye-laws relating to failure to meet obligations by any clearing member. Currently, clearing member charges 0.07 percent of the default amount per day for overnight settlement shortage of value more than Rs.5 lakhs, security deposit shortage, and shortage of capital cushion.
A penalty of 0.5% of the order value is levied in case of short reporting by trading/clearing members for a short collection of less than Rs.1 lakh and less than 10% of the applicable margin. However, a higher penalty of 1% of the order value is applicable on short reporting equal to Rs.1 lakh or equal to 10% of the applicable margin and above.
Frequently Asked Questions Expand All
In the cash market, you have VAR margins and extreme loss margins or ELM. In addition, there are ad-hoc margins from time to time and ASM in select stocks which show high volatility.
Mark to market is the daily marking of all positions to the closing price in futures and sell options so as to reduce the overnight risk and start the next day with risk covered.