Why are margin penalties charged?

Margin trading is a practice through which market investors can invest capital they don't own. To conduct a trade, the investor must only have a certain percentage of the total trade value. By margin trading, an investor can significantly increase their profits. But they can also lose more money than they actually have. A trade conducted at a fraction of its value is said to be leveraged. Leveraged positions entail substantial risks while also providing an opportunity for tremendous profits.

Due to the risky nature of margin trading, it is crucial that it is regulated and investors are aware of the potential losses they can face in case something goes wrong. Thus, there are strict regulations placed by SEBI, the exchanges, and the brokers on how much leverage can be granted to investors. Investors should be aware of these regulations and keep a keen eye on their margin statement to stay in compliance with them.

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What is a Margin Shortfall?

Investors entering a leveraged position are required to maintain a minimum amount in their accounts. This amount is said to be the upfront margin. The account has a margin shortfall if the investor fails to maintain the minimum amount.

The shortfall is the difference between the account balance and the required upfront margin. The minimum margin required to hold a leveraged position depends on the trade segment. If the trade is an equity trade, then the minimum margin is the sum of Value at Risk (VaR) and Extreme Loss Margin (ELM).

If the trade is a Futures and Options trade, the minimum margin is the sum of the Standardised Portfolio Analysis of Risks (SPAN) and Exposure margin. Also, while holding a leveraged position, its values might fluctuate; thus, the margin required to maintain the position also changes. Such changes are said to be non-upfront margins.

What is the Margin Penalty?

Margin penalties are fees levied on investors if a margin shortfall occurs in their trading account. The broker charges margin penalties to ensure that the minimum amount required to execute a trade is always present. If there is a margin shortfall, the investor is mandated to transfer funds to the account. Margin penalties are of the following two types.

• Upfront Margin Penalty - An investor is required to have a minimum upfront margin when entering a leveraged trade. If an investor fails to have the required minimum margin, an upfront margin penalty is charged, which is a certain percentage of the shortfall amount.
• Non-Upfront Margin Penalty - Once the upfront margin requirement is satisfied, any subsequent changes in the margin requirements are considered non-upfront margins. The investor must transfer adequate funds to the account to maintain the trade. If he fails, the broker will charge a margin penalty on the shortfall amount.

How Much is the Penalty?

The penalty is levied based on the shortfall amount. If the amount is below 1 Lakh or 10% of the applicable margin, then the penalty is 0.5% of the shortfall amount. Otherwise, the penalty is 1% of the shortfall amount. It is important to note that if the shortfall is for three or more consecutive days, a 5% penalty is charged for each subsequent shortfall. Also, if there are more than five shortfalls in a month, a 5% penalty is imposed. In commodities markets or MCX, a 5% penalty is imposed after three instances of margin shortfall. Investors are also liable to pay 18% GST on the levied penalty.

Conclusion

Margin trading provides investors with great opportunities to gain profits. But investors must be mindful of the losses they can incur if things go wrong. Margin shortfall penalties can be very hefty and cause severe losses for investors. Investors must always read their daily margin statements and ensure adequate funds are in their trading accounts to avoid penalties. Also, investors must assess their risks before entering leveraged positions to avoid situations where they might face losses and penalties.

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