In this blog, we will explore the process of pledging shares, the risks involved, and the effective risk management techniques that can be used to manage those risks. We will discuss the benefits and drawbacks of pledging shares, the share prices, and the shareholding pattern that investors must be aware of. By the end of this blog, you will have a better understanding of how pledging shares can help raise funds while managing risk effectively.
Definition
Pledging of stocks is a method by which investors or traders borrow money from the broker by “pledging” the stocks or shares held as collateral.
This means that shares, ETFs, and mutual fund units can also be pledged to avail loans.
This is similar to buying a car with a car loan or a house with a house loan.
In a car loan, you pledge the car as a collateral.
In the house loan, you pledge the house as a collateral.
In any other loan, you can pledge a land or a house or gold or any asset for collateral for securing the loan.
In pledging of stocks, you pledge the shares you already hold as collateral to borrow money to withdraw or buy more shares.
How To Do?
There are broadly three ways in which you can pledge your shares.
Loan Against Securities (LAS):
LAS is usually cheaper as compared to taking a personal loan.
In LAS, the balance gets transferred directly to your bank account.
Margin Trading Facility (MTF):
Margin Trading Facility (MTF) allows you to borrow money by pledging the stocks you already hold for buying new stocks.
In this method, the stocks held have a trigger price.
If the current market price falls below the trigger price, some units get sold automatically to make up for the margin shortfall. This scenario is called margin call.
You have to deposit more money so that the broker will not lose money in margin calls, just in case, if the value of the stocks you pledged fall.
Eg.,
If you want to buy a stock for Rs.100, you can pay only Rs.25 and borrow the rest of the amount by pledging the shares you already own.
In MTF, the shares are pledged to depositories after making the transaction.
Collateral Margin Facility:
Under the collateral margin facility, the investors can pledge the securities present in their brokerage accounts to avail extra margin for trading equity intraday, futures & options writing (equity and currency F&O).
However, after the recent regulatory changes, most exchanges allow
<= 50% margin MAX
for Futures & Options positions.
This means that if you use margin for open positions, you’ll have to fund the balance 50% requirement in cash or cash equivalents.
What is an open position?
- If an investor owns 500 shares, they have an open position in that stock until it is sold.
- The risk remains until the position is closed.
- Day traders open and close their positions in a matter of seconds and aim to have no open positions at the end of the day.
- Closing a short position requires buying back the shares while closing long positions entails selling the long position.
Haircut:
When investors pledge shares, a certain amount is deducted from the price of the collateral and the remaining amount is the margin (or funds).
Investors can withdraw the margin or buy new shares with the margin amount.
The amount deducted is called a ‘haircut’.
The haircut % and the maximum amount of money you’ll receive after haircut differs from stock to stock.
In some stocks, you can receive 85 to 90% of the value.
For others, margin amount you receive in hand after the haircut can be as low as 10 to 20% of the value of the stock.
However, there are a variety of charges such as processing fees, pledging fees, and more that must be closely studied when taking a LAS.
The Process
Every time a pledge is created on a stock, it has to be authorized via CDSL(Central Depositories Securities Limited) or NSDL(National Securities Depositories Limited).
The broker provides you with the money for trading or investing and the stocks or securities you pledge are kept safe with the broker.
The Math
The Value of The Share you Pledge V =
Floor (Previous Closing Price, Last Trading Price).
Value of the share is either the previous closing price or the last trading price, whichever is lower.
The Margin you will Receive M
M = V – Haircut
After the haircut is deducted, the balance starts reflecting in the available margin feature in your stock broker app.
You can now use this amount for buying new stocks.
Interest:
Usually, an investor has to pay the interest on the amount borrowed and a basic fee for pledging & unpledging of the stocks.
The interest charge levied on the borrowed funds is ideally between 8% to 18% (per annum).
Pledging fee is a small flat fee usually in the range of Rs 20 to Rs 30 plus GST for every stock that you pledge.
Risk Vs Returns:
While the prospects of earning superior returns by leverage are lucrative, this also includes the risk of a margin call.
The price of stocks fluctuates because of the volatility, and even if you are confident for the long term, your broker can ask you to deposit more funds because the market value of your collateral has decreased.
If you don’t, the broker may sell the stocks at loss to save their downside.
The decision of pledging stocks to secure more margin is entirely the choice of the trader or investor.
Due Diligence:
However, it is crucial to read all the terms & conditions and applicable charges carefully before pledging the shares.
Constant Vigilance:
Best Practice is to compare the interest charge across brokers to see what suits you best.
Demat Account:
To pledge shares, the investor should have a demat account and trading account mandatorily. This account must be carefully managed to ensure the security of the investment.
Risk Management:
Pledging stocks can be a useful tool for raising funds, but it is not without risks. Effective risk management is crucial to ensure that pledged shares do not become a liability for the investor.
The first step in effective risk management is a comprehensive risk assessment. This involves identifying and evaluating the various risks associated with pledging shares, such as changes in share prices, market volatility, and the shareholding pattern of the company. Once the risks have been identified, the next step is to develop a risk management process that includes strategies for mitigating risk and managing any identified risks.
Risk Mitigation Strategies:
Bear Market?
One such risk mitigation strategy is to sell the pledged shares if the share prices fall sharply, especially during a bear market. However, it is essential to have a clear plan in place for selling pledged shares and to ensure that it does not lead to a breach of any contractual obligations.
Shareholding Pattern:
Another important risk mitigation strategy is to manage risk through the shareholding pattern. This means diversifying the portfolio and avoiding overexposure to any particular stock or sector. Investors can also use stop-loss orders to minimize losses in case of unexpected market movements.
Risk Funnel?
In addition to these strategies, effective risk management also involves maintaining accurate records and regularly monitoring the demat and trading accounts. Investors must keep track of any changes in the share prices, margins, and collateral requirements and adjust their strategy accordingly.
Finally, it is important to note that pledging stocks carries inherent risks, and even the best risk management process cannot eliminate these risks entirely. Therefore, investors must be vigilant and take appropriate measures to manage their risk exposure.
Conclusion:
In conclusion, the process of identifying and mitigating the risks associated with pledging shares can be time-consuming and complex. However, by adopting effective risk management strategies, investors can minimize the potential downsides and unlock the benefits of using shares as collateral. The securities markets offer many opportunities for raising funds, but investors must approach these opportunities with caution and a clear understanding of the risks involved.
With proper risk management and research, pledging stocks can be an effective way of availing funds for trading or investing.
