When trading stocks, one of the key aspects traders encounter is the concept of margins. Margins offer a way to mitigate the risk of non-payment by the buyer and non-delivery of securities by the seller, thus ensuring a smooth functioning of the stock market.

To expand your horizons in the world of investing and trading, it is important to know how margins work in the cash market and how to make informed decisions when applying this idea in your trading experience.

• Margins in the cash market act as a security buffer for stock trades.
• Key margin types (VAR, ELM, MTM) address different stock market risk aspects.
• Margins reduce risk by ensuring financial commitments in volatile market conditions.

In simple words, margin in the cash market refers to a definite amount of money that the stock exchange requires from brokers to secure trades. The broker collects this amount from the investors and deposits it with the stock exchange.

In this way, margins manage the uncertainty involved in stock market trades, ensuring that both the buyer and seller uphold their end of the transaction. Similar to how insurance mitigates the risk of potential loss, margins manage the risks of volatile stock price movements.

Consider an example. When an investor buys stocks, there is always a risk that they might not pay the full price of those stocks on time. Similarly, sellers may not deliver the shares as promised. Margins serve as a buffer in such a scenario, ensuring that in volatile conditions, obligations are met and trades happen without disruption.

Suppose you decide to purchase 5000 shares of a company, each priced at Rs. 10. The total value of this transaction would be Rs. 50,000. Some brokers will allow you to pay for the shares on the next day. But the stock exchange needs some form of assurance that you will, indeed, follow through with the payment. This assurance is made in the form of a margin.

Now, if the stock exchange decides that a 10% margin will apply to this trade, you will have to deposit Rs. 5,000 (10% of the total transaction value) upfront. This margin ensures that you are financially committed to the trade and reduces the risk of you defaulting on your payment. The remaining money is typically paid by the date of trade settlement.

In the cash market, there are three main types of margins that play a key role in safeguarding trades. These are Value at Risk (VAR) margin, Extreme Loss Margin (ELM), and Mark to Market (MTM) margin. Each of these addresses different aspects of risk in the market. Take a look at each of these in detail below.

Value at Risk (VAR) margin

This is the most fundamental type of margin in cash markets. It determines the potential decline in the value of a stock in a single trading day. This is done by analysing historical price volatility and trends in price movement.

Value at Risk (VAR) margin helps the stock exchange calculate the maximum possible loss with a high degree of confidence – typically, with 99% confidence.

So, the exchange collects this margin upfront from the investor. Therefore, even if prices fall drastically, the financial obligations of the trade will still be met. In this way, VAR protects the stock exchange and the investor from potential financial loss.

Extreme Loss Margin (ELM)

Extreme loss margin adds another layer of protection to trades, covering those rare situations where losses exceed the amount that VAR margin accounts for. ELM protects against extreme and unexpected market conditions, like significant price shifts or a market crash.

ELM is determined by looking at the performance of a stock over the last six months. For instance, if a stock has exhibited high volatility in the last six months, the exchange will impose a higher ELM to ensure that all possible risks are properly mitigated. Therefore, ELM acts as a safety net in case the market moves unpredictably beyond the expected risk levels.

Mark to Market (MTM) margin

Mark-to-market margin is applied on a daily basis to ensure that the differences between the transaction price and the closing price of a stock are taken into account. For example, if the price of a stock falls after an investor makes a purchase, this margin covers the notional loss caused by this price decline.

Consider that you bought 100 shares at Rs. 1000 each. Now, by the end of the day, the price reduces to Rs. 900. In such a situation, you will face a notional loss of Rs. 10,000. In such cases, the MTM margin ensures that this loss is paid to the exchange before the next trading day, which maintains the financial integrity of the trade.

To sum it up, margin is an important risk mitigation strategy employed by the exchange to ensure the smooth functioning of the stock market.