Margins and Margin penalties when trading with leverage

What is Leverage?

When an equity or F&O trader takes a position greater in value than the funds or margins available in their account, such positions are said to be leveraged. This is typically done with the idea of generating a higher return on capital, but it entails taking a higher risk. Leveraged trades also give the ability to take a short view of a stock or the market, i.e., to profit from a trading idea that predicts stock prices going down.

Using F&O, a trader using leverage can also hope to generate returns by predicting volatility, arbitraging, and employing more such strategies. F&O is also used to hedge either a single stock or an entire portfolio. In the case of F&O, leverage is baked into the product, unlike in equity.Leveraged trades provide significant liquidity, cushioning volatility during events, and significantly help reduce impact costs for investors.

What is Margin?

With a leveraged trade (apart from option buying), since the exposure is larger than the funds available in a trader’s account, a trader can technically lose more money than the funds available in the account. So, if a trader bought 100 shares of stock X at Rs 1000 with only Rs 20,000 in the account, and if the stock price suddenly drops from Rs 1000 to Rs 500 for any reason, the trader would lose Rs 50,000. This additional Rs 30,000 loss beyond the Rs 20,000 available with the trader is the liability of the brokerage firm to settle.

If tens of thousands of customers lost money on the same stock, a brokerage firm that is not well capitalized could potentially go bankrupt if they’re unable to recover the debits from clients, thereby risking not just other customers, but the entire market.

To keep this risk in check, regulators require brokerage firms to collect a minimum margin for all leveraged trades. This minimum margin is called VAR+ELM (Extreme Loss Margin) for equity and SPAN+Exposure for F&O. Until last year, brokerage firms had the flexibility to give additional leverage over and above the minimum for intraday trades. This was a selling point for many firms. This is no longer possible after the introduction of peak margin regulations and today, margin requirements are uniform across the industry.

What is Margin penalty?

Margin penalty is a way for regulators to ensure that minimum margins are collected. Until last year, the minimum margin requirement was only on an end-of-day (EOD) position. This meant that for any open position, there had to be that minimum margin available in the trading account at the end of the trading day. The exchanges didn’t track margin requirements intraday. They charged a penalty if the required margins were not made available at the end of the trading day. After the introduction of peak margin checks that happen intraday, the penalty is also applicable for intraday margin shortfalls on positions.

The clearing corporation (CC) takes five random snapshots of all intraday positions and margins across customers during the day to determine whether a sufficient margin is available during those snapshots. If sufficient margins aren’t available either at the end of the trading day or in the intraday snapshots, a margin penalty is charged on the net shortfall amount. The penalty is 0.5% of the shortfall amount lower than Rs 1L, and 1% for higher than Rs 1L. This can go up to 5% in the case of shortfall for more than three instances in a month. These penalties are collected by exchanges and deposited in the core Settlement Guarantee Fund (core SGF).

Speaking of margin penalties, they are of two types.

1.      Upfront margin penalty:

This is applied if there isn’t sufficient margin in a trader’s account at the time of entering a trade. For example, if a trader had Rs 1L in the account and the brokerage firm allowed the customer to enter a position with a minimum margin (SPAN +Exposure) of Rs 1.1L, this would mean a shortfall of Rs 10,000, resulting in a penalty on the shortfall amount.

2.      Non-upfront margin penalty:

Theoretically, a non-upfront margin includes all such margins that need to be collected after the client enters a trade (after fulfilling the upfront margin requirement). When the client does not fund such additional margin requirements on time, it leads to a shortfall where a penalty may be charged. For example, if there are marked-to-market (MTM) losses in a futures contract, there is time until T+1 day to add the funds, failing which, it is considered a non-upfront margin shortfall and a penalty is applied. Similarly, when exchanges add ad-hoc margin requirements owing to volatility or physical delivery margins to stock F&O contracts on the last week of expiry, they are considered non-upfront margins.

Who bears the margin penalty?

A broker should bear the penalty if they allow a customer to trade without sufficient upfront margins. It should be on the customer if the customer doesn’t bring in additional margin requirements after taking a trade. In the same spirit, regulations state that an upfront margin penalty can’t be passed on to the customer by the broker, and that non-upfront can be passed.

This is where it gets tricky, especially in derivatives (F&O, CDS, MCX). After the introduction of the peak margin penalty last year, there are certain situations where even if the broker collects sufficient upfront margin while entering a trade, if margins go up after entering a position due to unpredictable market conditions, that resulting shortfall is also considered an upfront margin shortfall, putting the obligation on the broker.

Most brokers had taken a stance that since they ensured that sufficient pre-trade margins were available, any penalty on shortfalls owing to unpredictable market volatility or any other reason after taking a position is not an upfront margin penalty but non-upfront, which can be passed on to the customer who took the position. Typically, in these scenarios, customers are alerted of the margin shortfall and requested to add funds or close certain positions to cover the shortfall.

Ideally, if the margin goes up on the F&O portfolio either due to volatility or in the case of option writing due to position moving against the customer, there should be time provided till T+1 day to bring in additional margins. This is like in Futures, where there is time till T+1 to transfer any marked-to-market losses. In cases where exiting positions increase margins, it should be treated as a non-upfront margin penalty, and the onus should be on the customer to comply with the regulation.

Source: www.zerodha.com