However, in the process of this drastic transition, where the Nifty started declining from the high level of 6200 to the lows of 4500, many investors and traders have lost their capital. Even though the Nifty is again going to climb back, the traders and investors have lost their money because some sell stock orders were executed at the lowest of the low values.
Majority of that has been attributed to the MTM effect or the Mark To Market Factor. In this article, I’ll explain how the MTM effect works. What is Mark to Market and how does that affect a trader’s position. I will also touch upon the associated things – Margin call requirements.
Some brokers like ICICIdirect have a strict requirement that you MUST have the entire money in your trading account, before you can buy any shares through them. So if I want to buy shares worth 10,000 then I must have 10,000 already deposited in my ICICI account and from there I should allocate that 10,000 for trading purpose. Then and only then I will be allowed to buy shares or buy stocks as per my stock picks.
However, majority of the brokers, like IL&FS, etc. do NOT require the entire amount to be deposited with them. Hence, if I have a brokerage account with IL&FS, Motilal Oswal or Angel broking (just for an example), then I can place my buy stocks order even without having a penny in my account. So if I wish to buy shares worth 100,000, I just place a call to my IL&FS broker and he places the order for me in the exchange. If it gets executed, due to T+3 settlement cycle (or T+1 in the US stock markets or T+3 in UK stock markets), I have 3 days time to provide the required money to my broker. Due to T+3 cycle, the shares will come to my demat account only on the 3rd day and the cash should go from my account only on the 3rd day. Hence, that gives me a leveraged position for 3 days.
There can be other brokerage firms which require a percentage of money to be kept with them initially. Say 20%. So if I want to place an order of 100,000, then I should initially have 20,000 with the broker. Ultimately, it depends upon the criteria set by the broker you are dealing with.
So I place the order, I pay the broker in (or within) 3 days time and I get the shares. All fair and good. But there can be a problem.
Remember you will be required to sign at as many as 45 different places on a brokerage account document to open a trading account? There are certain conditions mentioned in that which we obviously ignore and take for granted.
Every brokerage firm has a Risk management division. This division decides the amount of risk they can bear and depending upon that they decide the limit upto which the client’s positions can be leveraged.
However, there is a requirement for the brokers to comply with the MTM or Mark to market factor. The MTM factor means that for all leveraged positions, the broker will be required to have cash, in case the market price of the stock starts falling down.
Let’s take an example. Suppose Microsoft is trading at $20. Due to some problems, the stock price starts to go down. There may be a set limit of providing extra cash to cover for positions if the stock price falls by say 25%. So if the stock price of Microsoft touches $15 (25% below), then the brokers (and ultimately their clients) who are holding positions in Microsoft in this leveraged style (without depositing the entire buy amount), will be required to pay the money to cover their losses in the leveraged positions.
So in the last 2-3 days, the same situation was happening in the Indian markets. Traders and investors had such leveraged positions with their brokers. As the stock prices started to tumble downwards, the brokers were required (as per their risk management divisions) to cover for the losses in the leveraged positions due to stock price meltdown. Remember, a broker is only an intermediary in the trading process. The actual liability lies with the trader or investor or the client who is trading. Hence, the broker, on behalf of the clients, was required to have cash for the leveraged stock positions.
Continue to Part 2: How Margin calls are placed and what is required?
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