MC Explains | What are margins in trading and how are they calculated?

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“Peak Margins were introduced to prevent brokers from offering intraday leverage (in derivatives) to clients. Before peak-margin rules were introduced, overleveraging was the norm as brokers lured retail traders to trade with a fraction of the required margins,” said Tejas Khoday, CEO of FYERS, one of the biggest online trading platforms. “For example, if a NIFTY futures contract required Rs. 1 lakh in upfront margins, brokers would offer it at Rs 10,000 to Rs 25,000 only. Considering that index futures contracts are leveraged by 10x (margin at 10%), clients were levered 40x to 100x on every derivative trade because of the broker intraday margin leeway. That's insanely high and usually magnifies losses. In rare cases, it also led to broker defaults.”

Margins for trading in stocks already had a floor of 20%, or the leverage was capped at 5x.

But the traders and brokerages complained that the peak-margin rule was unfairly penalising them, and the market regulator changed the rule to make it friendlier. More on that later.

Since the changing margining rules have been confusing even the most seasoned traders, and leaving them vulnerable to fraud, here’s a breakdown of the essentials.

First, what is a margin?

Margin was conceived as a way to get people to honour their trades. But it has come to operate more as a leverage instrument.

Usually, an order in the capital markets takes two days for delivery trades. That is, place an order today (or T day), make the payment to the broker by the end of the next day (or T+1 day) and then the brokerage pays the exchange the day after that (or T+2 day) and transfers the security to the buyer’s account.

Between T and T+1 days, if the price of a security falls, then a buyer may not have an incentive to make the payment. Or if in these two days, if the price of the security goes up, then the seller may not have an incentive to transfer the shares. Therefore, the margin was conceived as a token money, to get the trader to place some “skin in the game.”

But margins are also loans in the way they function.  Here’s how. Margins are calculated as a percentage of the value of the trade placed. For example, if a brokerage gives a trader 20% margin, and there is Stock A available for Rs 20 a unit. Then, the trader can place an order for 5 units for Rs 100. By paying Rs 20, the trader can buy for Rs 100. Therefore, the brokerage essentially loans Rs 80 to the trader/investor.

In India, brokerages do not charge an interest for intra-day margins but charge indirectly through a higher brokerage fee, said Khoday.

How are margins decided? 

Margin requirements for every stock or index or derivative are different. They are set by the respective exchanges, based on the volatility of the security that is being traded, and the requirements vary every day. Higher the volatility, higher the margin. A brokerage can add to that base number if they perceive a higher risk, but it cannot have a margin lower than the minimum set by the exchange.

An exchange sends out a circular on the margin requirements for various stocks and indices periodically. For example, the NSE posts VaR and SPAN margin requirements six times a day. One in the beginning and end of the day, and four times at different points in the day.

What are the different kinds of margins? 

When a trade is executed, a brokerage account needs to have money to meet two margins–Value at Risk (VaR) Margin for stocks, and Standard Portfolio Analysis of Risk or SPAN Margin (calculated using a trademarked software) for derivatives. The broker may add an Extreme Loss Margin (ELM) for stocks and an Exposure Margin (EM) for derivatives. Or VaR+ELM for stocks and SPAN+Exposure for Futures and Options (F&Os).

VaR is a volatility measure calculated using historical data, and it tells an investor the maximum extent (in percentage) to which the value of an asset can fall in a day, with a 99% confidence level. Or the maximum loss it can face in 99 of the trading days. VaR margin, which is a multiple of VaR, is set to cover such a fall. Extreme-loss margins (ELM) are for events that cause volatility in excess of historical volatility or VaR. ELM comes in handy in markets that are seeing exceptional volatility.

SPAN margin is calculated for a derivative or an F&O position. It is generated using a trademarked Standard Portfolio Analysis of Risk (SPAN) software, which was developed by the Chicago Mercantile Exchange (CME). It considers 16 different scenarios with different prices and volatility, and takes the worst-case scenario based on the highest loss suffered to decide on the margin. The broker may also add an exposure margin, to cover any additional risk.

“Exchanges levy an extra margin to add a layer of safety over and above what SPAN requires. In India, it is known as Exposure margin,” said Khoday, adding that exposure margin is to derivatives what ELM is to stocks.

At the end of the trading day, if there is a mark-to-market loss in a trader’s holding, then a mark-to-market margin is levied. Say the value of Stock A has started to fall and has reached Rs 93 as the market is about to close, then the trader will need to ‘top up’ the account with Rs 7 (Rs 100 minus Rs 93). This is in addition to the Rs 10 that is already in the account.

“If the price has fallen before 2.30 pm, then at 2.30 pm, the broker will call and ask for the additional amount. If the price has fallen after market closing at 3.30 pm, then the broker will ask for the top up the next trading day by 10.30 am or 11 am,” said Rajesh Sriwastava, a professional trader with over two decades of experience.

If the trader does not pay when these calls are made, then the broker will sell the position to recover the loan/leverage amount.

What was the peak-margin issue?

In August, traders sighed in relief when the Securities and Exchange Board of India (SEBI) tweaked its peak-margin rules.

Two years ago, the market regulator had started with the peak margin rules. That is, instead of calculating margins based on end-of-day positions, margins would be taken from four random periods in the market and the highest margin would need to be maintained in brokerage accounts.

If margins were calculated based only on end-of-day positions, then traders were able to take highly leveraged and therefore highly risky positions intraday (or during a trading day) if they squared off these positions before end of day.

For example, if a trader closed the previous day with positions worth Rs 1 crore and had maintained a margin based on that but took another Rs 2 crore-worth of positions in the current trading session and closed it by EoD, the additional Rs 2 crore will not require additional margin. So essentially, a trader could even take an additional Rs 2 crore worth positions with 0% additional margin.

Yes, the broker was taking an additional risk with such a trade, but it also brought the broker higher trading volumes in a highly competitive market.

The peak margin rule became highly difficult to implement. This was because SPAN margins can be volatile and a person who took a position with sufficient margin at the beginning of the day could face a penalty if the value of their F&O position fell during the day and margin requirement went up. For example, if the trader started their day with Rs 50,000 margin, which was sufficient to cover that particular trade, but if the margin requirement went up intraday to Rs 50,700 because the derivative market can be volatile, then the trader could face a penalty even though the trader has not taken a new position.

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So, starting August, the regulator said that in the intraday derivatives segment, the margins could be calculated using a fixed, beginning of the day (BoD) positions. If the trader has given sufficient margin in the beginning of the day for that first trade, then even if margin requirement went up intraday, the trader would not be penalised for it. The margin requirement would then be calculated only at the end of day (EoD), as it was before.

As of today, the trader only has to comply with BoD and EoD margin requirements.