Margin Trading and Types of Orders

Module-I

Margins

• After implementation of T+2 rolling settlement with effect from April 1, 2003 the stock exchanges now have been advised to follow the structure given by SEBI.

Categorisation of stocks for imposition of margins

• The risk containment measures for the scrips shall be based on their volatility and liquidity. The scrips shall be classified into three groups’ viz., stocks having traded at least 80% (5%) of the days for previous eighteen months (from July 1, 2001) would constitute Group I and Group II.

• Out of the scrips identified above, the scrips having mean impact cost of less than or equal to 1% shall be categorized under Group I and the scrips where the impact cost is more than 1%, shall be categorized under Group II.

• The remaining stocks shall be categorized under Group III.

Categorisation of stocks for imposition of margins

• The impact cost shall be calculated at 15th of each month on a rolling basis considering the order book snapshots of the previous six months. On the basis of the calculated impact cost, the scrip shall move from one group to another group from the 1st of the next month.

• The impact cost shall be the percentage price movement caused by an order size of Rs.1 lakh from the average of the best bid and offer price in the order book snapshot. The impact cost shall be calculated for both, the buy and the sell side in each order book snapshot. The computation of the impact cost adopted by the Exchange shall be disseminated on the website of the Exchange.

VaR based margin • The margin requirements for scrips in the compulsory settlement

mode is determined based on a scientific model, i.e., the Value of Risk (VaR) model from June 2001.

• VaR is related to the volatility variance of the underlying stock price, but it is not a measure of volatility. VaR defines the maximum loss a portfolio can suffer within a time horizon (say a day) at a pre-specified probability level. For example, if a 99% VaR is specified as Rs.10, it should be interpreted as in 99 out of 100 days the loss of the portfolio can suffer will never exceed Rs.10.

• It should be noted that this is not the same thing as VaR is the maximum possible loss when the markets turn unfavourable. The maximum potential loss a portfolio can suffer when things turn unfavourable is the entire value of the portfolio itself.

• To put it in simple terms a 99% VaR will indicate the maximum loss that portfolio can suffer in 99 per cent of times. Conversely, it is the minimum loss that a portfolio can suffer in 1% worst cases.

VaR based margin • For the stock in Group I, the VaR will be scrip VaR (3.5 sigma)

computed in a manner specified for the scrip on which stock futures are traded. On the stocks in Group II where the impact cost is more than 1%, the VaR margin shall be higher of scrip VaR (3.5 sigma) or three times the index VaR, and it shall be scaled up by . For the stock in Group II, the VaR margin would be equal to 5 times the index VaR and scaled up by.

• For determining the margins for Group II and Group III, the minimum index VaR would continue to be taken as 5% as at present.

• The volatility estimates for the scrips and the index for the VaR shall be computed on the price differential of 2 days. The VaR calculated by an exchange at the end of the previous day would be used for the purpose of margin calculations for the transactions carried out on the day.

Mark to market margin

• Mark to market margin is computed on the basis of mark to market loss of a member. Mark to market loss is the national loss which is the difference between the current market price and the contract price in respect of the outstanding trades.

• Mark to market margin is calculated by marking each transaction in a scrip to the closing price of the scrip at the end of trading. In case the security has not been traded on a particular day, the latest available closing price, at the NSE is considered as the closing price.

Mark to market margin

• In the event of the net outstanding position of a member in any security being nil, the difference between the buy and sell values would be considered as national loss for the purpose of calculating the mark to market merging payable.

• MTM profit/loss across different securities within the same settlement is set off to determine the MTM loss for a settlement. Such MTM losses for settlements are computed at client level.

Margins based on turnover and exposure limits (initial margins)

• Intra-day turnover limit Members are subject to intra-day trading limits, intra-day gross turnover (buy + sell) of the member should not exceed twenty five (25) times the base capital (cash deposit and other deposits in the form of securities or base guarantees with NSCCL and NSE).

• Members violating the intra-day gross turnover limit at any time on any trading are not be permitted to trade forthwith. Members’ trading facility is restored from the next trading day with a reduced intra-day turnover limit of 20 times the base capital till additional deposits (additional base capital) are deposited with NSCCL.

Margins based on turnover and exposure limits (initial margins)

• Members are given a maximum of 15 days time from the date of the violation to bring in the additional capital, upon members failing to deposit the additional capital within the stipulated time, the record turnover limit of 20 times the base capital would be applicable for a period of one month from the last date for providing the margin deposits.

• Upon the member violating the reduced intra-day turnover limit, the above-mentioned provisions apply and the intra-day turnover limit bill be further reduced to 15 times. Upon subsequent violations, the intra-day turnover limit will be further reduced from 15 times to 10 times and then from 10 times to 5 times the base capital. Members are not permitted to trade if any subsequent violation occurs till the required additional deposit is brought in.

Gross exposure limits • Members are also subject to gross exposure limits.

Gross exposure for a member, across all securities in rolling settlements, is computed as absolute (buy value – sell value), i.e., ignoring +ve and –ve signs, across all open settlements.

• Open settlements would be all those settlements for which trading has commenced and for which settlement pay is not yet completed. The total gross exposure for a member on any given day would be the sum total of the gross exposure computed across all the securities in which a member has an open position.

Gross exposure limits

• Gross exposure limit would be: • Total base capital Gross exposure limit • Upto Rs.1 crore 8.5 times the total base

capital • > Rs.1 Crore 8.5 crore + 10 times the

total base capital in excess of Rs.1 crore.

Gross exposure limits

• The total base capital being the base minimum capital (cash deposit and security deposit) and additional deposits is not used towards margins in the nature of securities, base guarantee, for, or cash with NSCCL and NSE.

Violation charges • A penalty of Rs.5000 is levied for each violation of gross exposure

limit and intra-day turnover limits, which shall be paid by next day. The penalty is debited to the clearing account of the member; non-payment of penalty in time will attract penal interest of 15 basis points per day till the date of payment.

• In case of second and subsequent violation during the day the penalty will be in multiples of Rs.5000 for each instance (for example in case of second violation for the day the penalty levied will be Rs.10,000, Rs.15,000 for third instance and so on).

• In respect of violation of stipulated limits on more than one occasion on the same day, each violation would be treated as a separate instance for purpose of calculation of penalty.

• The penalty as indicated above would be charged to the members irrespective of whether the member brings in additional capital subsequently.

Types of orders

• Before comparing alternative trading practices and competing security markets, it is helpful to begin with an overview of the types of trades an investor might wish to have executed in these markets.

• Broadly there are two types of orders: market orders and orders contingent on price.

Market Orders

• Market orders are buying or selling orders that are to be executed immediately at current market prices.

• For example, our investor might call her broker and ask for the market price of IBM. The broker might report back that the best bid price is $90 and the best ask price is $90.05, meaning that the investor would need to pay $90.05 to purchase a share, and could receive $90 a share if she wished to sell some of her own holdings of IBM.

• The bid-ask spread in this case is $.05. So an order to buy 100 shares “at market” would result in purchase at $90.05, and an order to “sell market” would be executed at $90.

Market Orders • This simple scenario is subject to a few potential complications.

First, the posted price quotes actually represent commitments to trade up to a specified number of shares. If the market order is for more than this number of shares, the order may be filled at multiple prices.

• For example, if the asked price is good for orders up to 1,000 shares, and the investor wishes to purchase 1,500 shares, it may be necessary to pay a slightly higher price for the last 500 shares.

• Second, another trader may beat our investor to the quote, meaning that her order would then be executed at a worse price. Finally, the best price quote may change before her order arrives, again causing execution at a price different from the one at the moment of the order.

Price-Contingent Orders

• Investors also may place orders specifying prices at which they are willing to buy or sell a security. A limit buy order may instruct the broker to buy some number of shares if and when IBM may be obtained at or below a stipulated price.

• Conversely, a limit sell instructs the broker to sell if and when the stock price rises above a specified limit. A collection of limit orders waiting to be executed is called a limit order book.

Stop orders

• Stop orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price limit.

• For stop-loss orders, the stock is to be sold if its price falls below a stipulated level. As the nave suggests, the order lets the stock be sold to stop further losses from accumulating.

• Similarly, stop-buy orders specify that a stock should be bought when its price rises above a limit. These trades often accompany short sales (sales of securities you don’t own but have borrowed from your broker) and are used to limit potential losses from the short position.

Figure 1.1 organizes these types of trades in a convenient matrix.

Condition

Action

Price below the Limit Price above the Limit

Buy Limit-Buy Order Stop-Buy Order

SellStop-Loss Order Limit-Sell Order