Why should there be margins?
Just as we are faced with day to day uncertainties pertaining to weather, health, traffic etc and take steps to minimize the uncertainties, so also in the stock markets, there is uncertainty in the movement of share prices. This uncertainty leading to risk is sought to be addressed by margining systems by stock markets.Suppose an investor, purchases 1000 shares of 'xyz' company at Rs.100/- on January 1,2008. Investor has to give the purchase amount of Rs. 1,00,000/- (1000X100) to his broker on or before January 2, 2008. Broker, in turn, has to give this money to stock Exchange on January 3, 2008.
There is always a small chance that the investor may not be able to bring the required money by required date. As an advance for buying the shares, investor is required to pay a portion of the total amount of Rs. 1,00,000/- to the broker at the time of placing the buy order. Stock Exchange in turn collects similar amount from the broker upon execution of the order. This initial token payment is called margin.
Remember, for every buyer there is a seller and if the buyer does not bring the money, seller may not get his/her money. Margin is levied on the seller also to ensure that he/she gives the 100 shares sold to the broker who in turn gives it to the Stock Exchange. Margin payments ensure that each investor is serious about buying or selling shares.
In the above example, assume that margin was 15%. that is investor has to give Rs. 15,000/- (15% of Rs. 1,00,000/-) to the broker before buying. Now suppose that investor bought the shares at 11 am on January 1.2008. Assume that by the end of the day price of the share falls by Rs. 25/-. That is total value of the shares has come down to Rs. 75,000/-. That is buyer has suffered a notional loss of Rs. 25,000/-. In our example buyer has paid Rs. 15,000/- as margin
but the notional loss, because of fall in price, is Rs. 25,000/-.. That is notional loss is more than the margin given.
In such a situation, the buyers may not want to pay Rs. 1,00,000/- for the share whose value has come down to Rs. 75,000/-. Similarly, if the price has gone up by Rs. 25/-, the seller may not want to give the share at Rs. 1,00,000/-. To ensure that both buyers and sellers fulfill their obligations irrespective of prices movements, notional losses are also need to be collected. Prices of shares may keep on moving everyday. Margins ensure that buyers bring money and sellers bring shares to complete their obligations even though the prices have moved down or up.
