Recently, the Securities and Exchange Board of India tightened the rules around stocks getting included in futures and options (F&O). This created a lot of panic as a number of mid- and small-cap companies got excluded from the list, which meant that traders and speculators had to wind up their existing positions. This led to margin calls and sharp corrections in many stocks.
What is margin?
Ordinarily, when you buy stocks, you have to pay the total transaction value to your broker within the appropriate time limit. In case of derivatives and margin trading, you only need to pay a portion of the entire trade value. So if you are going to short-sell Nifty futures worth Rs 10 lakh, you have to pay your broker only Rs 2-2.5 lakh for the transaction. By using this margin, investors can potentially take higher exposure for a lower cash outgo. Now, let’s say that Nifty declines 10%, for the Rs 10 lakh short position, you stand to gain Rs 1 lakh, which is a 40% gain on the amount you paid or the margin money of Rs 2.5 lakh. This amount then gets credited to your trading account. But if you lose Rs 1 lakh, it will be debited against the Rs 2.5 lakh you have maintained as margin.
While certain derivative transactions necessarily require a margin commitment, brokers also offer a product where shares can be bought just by paying a margin.
The flip side or risk in using margin is that if the stock or index movement is not favourable, then you stand to lose a lot as well. Margin can be maintained in cash or in the form of stocks that are already there in your trading account.
How does it get triggered?
Basically margin for a stock or index is calculated based on the price volatility and is different for each. Now if, say, on a given day, stock price declines 5% the mark-to-market loss on your position is more than the limit prescribed by your broker. This means your position has gone into a big loss and the margin you have will not be sufficient and you will be required to give more margin money. This is called additional margin.
Keep in mind that if the broker ascertains that the margin is not enough (margin is a factor of volatility in the underlying security; while certain F&O transactions have fixed margins in other specific margin products offered by brokers, the value can vary), he can close your position without informing you (that’s the end of the trade), so you will lose the money you put initially. If, on the other hand, the broker informs you and you give the additional margin required, but the stock keeps moving in the wrong direction, your losses will keep adding up. The catch here is that you will have to square off or close your position at least once a month at the time of derivatives settlement (which is not the case if you simply buy and hold). If there is a loss on your margin position, you have to pay up and you may never get a chance to recoup losses if the market changes direction thereafter.
These kind of issues arise when you use derivatives and margin trading for speculative trades. If there are sudden sharp movements in prices for unforeseen reasons, the margin call can be much higher than you anticipated and if you don’t have money, your stocks will get sold. Once that happens, prices fall further till the situation normalizes.