Introduction

Have you ever pledged your gold jewellery for a loan and noticed the lender doesn’t give you the full market value? That deduction in this case is a safety margin – and it's called as haircut. When you pledge shares to borrow funds, the lender applies a haircut in stock market terms. This reduces the loanable value to protect against price reductions.

For example, if you have shares valued at ₹5 lakhs, the bank may provide only ₹4 lakhs. That ₹1 lakh deduction is the stock market haircut. Remember, this is not a penalty; it, instead, is a financial cushioning. In fact, experts define a haircut as a risk-adjusted calculation that serves both you and the lender.

Now, without further ado, let us dive deeper to comprehend “what is haircut in stock market” and its many nuances.

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What is a Haircut, and Why is it Crucial?

As per the stock market jargon, a haircut in the stock market is the gap between the current market value of your asset (usually shares) and the value assigned to it by a lender when used as collateral. This "trimmed" value accounts for potential volatility, market risk, and liquidity concerns.

Why is this done? Abrupt market downturns are a concern for lenders. If your pledged shares lose value, they need a buffer to recoup their dues. That is why a haircut share market technique is their safety mechanism.

Think of it like the “discount” a bank takes to ensure the value of your asset won’t drop below the loan amount.

How Does Haircut Work in Loans Against Shares?

Let us say you want to unlock cash from your stock portfolio without selling your investments. You can acquire a loan by pledging your shares to your bank or broker. This is referred to as margin against shares, or MAS. Here is how it functions -

• Pledge shares: You initiate a pledge request through your Demat account or broker.

• Haircut applied: The broker lowers the value of your collateral in accordance with the haircut, which is calculated in stock market terms. A ₹1 lakh portfolio gives you ₹75,000 in credit if the haircut is 25%.

• Utilise the loan: You can employ the borrowed funds for intraday trades, F&O trading, or short-term liquidity.

Lenders impose a haircut on the share market value based on risk profiles. Highly volatile or illiquid stocks may get a haircut as high as 50%. Similarly, well-established names might have only a 15% deduction.

Why do lenders do this? For one, liquidity risk – shares that can’t be sold quickly might leave lenders exposed. Second, volatility – a stock might fall 30% in a day, and the haircut stock pledge ensures lenders aren't left with a deficit.

It is imperative to know how haircut percentages vary by stock, given it is essential to assess your stock’s category before pledging.

Factors Affecting Haircut Percentage

Now that you know what haircut is in stock pledge, let’s focus on what influences the haircut's size. Numerous factors are involved:

• Volatility: Stocks with frequent price swings attract a higher haircut in stock market calculations. These could include mid-cap or penny stocks.

• Liquidity: Shares that trade actively on exchanges (like those in the Nifty 50) are easier to offload. And, therefore, they receive lower haircut share market values.

• Sector and credit risk: Generally speaking, equities in well-established businesses like banking or FMCG receive better treatment than those in startups or expanding sectors.

Before pledging, inspect your broker's stock haircut list. Blue-chip stocks like Infosys or Reliance, for example, may have haircuts as low as 10–15%. In contrast, a relatively unknown startup might have one as high as 50-60%.

Experts suggest regularly reviewing haircut tables. Being aware of the current rate helps you plan more effectively. It is particularly advantageous if you are using your holdings for hedging or active trading.

Haircut vs. Margin Call: The Safety Dance

It is easy to confuse a haircut in stock pledge with a margin call – but they serve different purposes.

A haircut share market is pre-emptive. It reduces the loan value from the outset. A margin call occurs after the market value of the pledged securities declines more than anticipated.

Consider this: You pledge ₹1 lakh worth of shares. The broker applies a 20% haircut stock pledge, and you get ₹80,000 as a loan. If the market crashes and your shares are now worth ₹60,000, your broker will initiate a margin call.

You might have to pledge additional shares at this point. Alternatively, you could pay back a portion of the loan to retain your margin need.

Why Should You Care?

Understanding the haircut in stock market dynamics is critical for you if you invest or trade actively. It influences how much liquidity you can extract from your portfolio over the long term. A higher haircut lowers your borrowing capacity.

If you trade with MAS, it helps you optimise your collateral approach. If you are familiar with your broker's stock haircut list, you can increase leverage by pledging effective, low-haircut equities.

Pro tip: You may borrow wisely and risk-free if you understand what a stock market haircut means. Hence, always check updated rates. Also, avoid pledging high-volatility stocks unless you can handle margin fluctuations.

Conclusion

Before pledging shares, always ask your broker or banker about applicable haircut share market rates. Your borrowing capability and risk exposure may be impacted by this tiny but important proportion. Comprehending what haircut is in the stock market with an example makes you ready to make more informed financial decisions.