Margin Money – Meaning, Calculation & Types

Margin money is an amount traders pay their respective brokers to take exposure in stock or its derivatives. Brokers collect margin money on behalf of the stock exchange to cover the credit risk that a trader takes.

For example, let’s say that a trader wants to buy some shares but doesn’t have the total money required. In this scenario, the trader can pay the broker a part of the total amount as margin money to take a position in that stock. 

The Indian stock market has a settlement cycle of T+1 day. On the trading day, margin money would be collected. The trader needs to pay the remaining money on the next trading day to take delivery of shares, failing which margin money collected by a broker will be adjusted against the daily price fluctuation of the stock, and a penalty will be charged to the trader. The remaining margin money will be credited to his trading account.

Margin money provides safety to a broker and the stock exchange. Every broker has margin money requirements displayed in trading terminals and on their websites.

Why is Margin Money Collected?

Margin money collection is a standard risk management procedure that a stock exchange practices. The clearing corporation of the stock exchange guarantees every trade, and they need a safety assurance collected as a margin to recourse upon.

Margin inculcates a sense of responsibility among traders and investors since they have invested a sum of the amount as a margin to trade, helping them make rational decisions.

There are circumstances when an investor fails to pay for  trade by a stipulated date. Margin money is an initial advance payment to the broker, which safeguards such adversities.

Stock exchanges collect margin money from a broker as a token payment when an order gets executed. 

Share price fluctuates regularly in the stock market. If the price goes down at the end of the day, the broker will mitigate losses through the margin collected. Margin collection is essential to know an investor’s intention and willingness to buy the shares.

Different Types of Margins in the Stock Market

Margin has been categorically divided into two market types, cash market and derivatives market.

Cash Market Margin

1. Value at Risk Margin (VAR): It represents the amount of statistical and quantifiable risk associated with a stock during a particular time frame. To understand clearly, VAR is the amount that could be at risk due to the stock’s price fluctuation.

It is an upfront margin to be paid immediately before a trade. Margin is calculated based on historical stock price volatility, and the estimated value indicates how much stock could fall over the next day. This margin covers loss taken by a trader in a single day.

2. Extreme Loss Margin (ELM): An additional margin is collected along with the VAR margin. It is intended to cover losses outside the VAR margin. This value is fixed at the beginning of every month and calculated based on price data of the past six months.
3. Market to Market Margin (MTM): This is a margin on open trade position taken by the trader. It is the difference between the transaction price and the stock’s closing price at the day’s end. 

Derivatives Market Margin (Futures and Options)

1. Initial Margin: This margin is collected when opening a future long or short position and a short position in an option. It is calculated using software called SPAN, which uses a scenario-based approach for the assumption of price and volatility, and this margin constantly changes. The possibility of maximum loss is calculated upfront that is to be paid by the trader. 
2. Exposure Margin: This margin is similar to the extreme loss margin. It is collected in addition to the initial margin while opening a new position in future or stock. Previously, brokers didn’t charge the exposure margin. But now, managing all trades as per SEBI orders is mandatory. Now, the exposure margin is levied on top of the initial margin and varies between 5% and 8% depending upon the stock’s volatility and underlying risk.

Peak Margin

It is the minimum margin a broker collects from traders based on all open positions at any time during the market hours, either in cash or pledged securities.

This margin is the minimum margin required to trade the stock. It varies between 20%-30% of the price of a stock.

This margin system was introduced by SEBI in 2020. The old system of high leverage-based trading was replaced with a more conservative approach by reducing the leverage provided by the brokers’ .

Margin Requirement Rules in the Indian Stock Market

Margin Requirement rules for three types of trade are classified as follows:

• For Equity Delivery: For delivery-based trades, the amount is specified by the exchange, which is required on the spot to execute the transaction. It includes Value at Risk Margin (VAR) and Extreme Loss Margin (ELM). Few brokers charge the total amount of the stock value that is to be paid in advance.
• For Equity Intraday: The trader has to keep VAR and ELM as specified by the exchange to execute a trade. An additional margin is to be held as a peak margin in the form of cash or securities throughout the day based on the size of the trade position. Equity intraday margins vary from 20%-30% of the price of a stock.
• For Equity Derivatives: A combination of SPAN and Exposure margin is collected upfront by the exchange. After the introduction of the peak margin rule by SEBI, the margin requirement for derivatives trading has been set at 25% of the total contract value for stocks and 15% for index derivatives.

A derivatives trader’s account must be funded sufficiently to avoid margin calls and attract penalties levied by the exchange. Online margin calculators are available on broker websites to help calculate margin requirements. 

Final Word

Margin is the least amount a broker collects from his client before executing a trade. Stock exchanges enforce it as a part of risk control, and brokers are bound to follow them.

On the other hand, margin enhances a trader’s buying power with leverage to make more purchases than their capital; however, it also may result in unanticipated losses.

A trader must use the borrowed margin wisely and only use what they can afford. There should be ample margin money kept to fund derivatives trading. 

The Securities and Exchange Board of India (SEBI) allows margin trading under strict guidelines. Failing to adhere to them can attract large sums of penalties. They keep changing margin collection rules regularly to ensure investors’ safety and the sanctity of financial markets.

Frequently Asked Questions