Share pledging is a useful practice that top traders and investors do to take positions in markets requiring margin without having to liquidate their existing positions.
Many investors tend to have stocks and exchange traded funds (ETFs) bought and kept for a long term, seeing their vision for the respective company or the economy. However, the more an investor parks his money into these securities, the more limited their cash margins will be, due to which they can lose out on trading opportunities. To counter this, brokerage firms provide the choice to an investor where he/she can pledge the stocks or ETF they own as ‘collateral’ in exchange for trading margin.
We shall explain what this means in this article.
Why should I pledge my shares?
Say, you are bearish on the Nifty Bank index and you see an opportunity to write call options to hedge your long-term positions in banking stocks. However, due to the amount you have invested in these shares, you don’t have the required margin in your account to write call options.
What you can do in this scenario is you can put these shares as collateral in exchange for this margin amount that you can use to write call options on Nifty Bank. You’ll continue to receive the benefits of the share the way you would’ve owned it, like dividends and stock splits.
This exchange works the same way as a property loan, wherein the bank you had taken the loan from can take hold of your property in case of default. Similarly, your broker can take these banking shares away from you if you end up on a loss on the margin that was given to you.
What is a haircut?
In the context of share pledging, a haircut refers to a percentage cut from which you can receive a margin for your collateral. That is if a security has a haircut of 10% set by NSE, you will receive Rs 90 for every Rs 100 you pledge. For the example of Nifty Bank shares, for every Rs 1,00,000 you pledge, you can use the entire Rs 90,000 to write maybe one lot of options.
Can I pledge any share that I know?
Your broker is unlikely to accept any share you are willing to pledge. There will be a select set of securities that your broker will accept pledging as collateral for margin. These includes popular companies, Liquid BeEs and other ETFs like Nifty BeEs.
Can I trade anything using this margin?
No. You will only be able to make trades that require this margin amount, and that includes :
- intraday positions in equity
- intraday or overnight positions in futures
- writing call or put options
You will be unable to use this amount on carrying equity positions and buying options as they don’t require/need margin.
Can I trade with just this margin?
Not always. In your overnight positions in futures and options, 50% of your margin needs to compulsorily come in cash, and the remaining 50% can be in terms of collateral margin. So assume you take positions that require a margin of Rs 1,00,000 you will need at least Rs 50,000 as cash in your brokerage account irrespective of how much collateral margin you have. Assuming you don’t have this Rs 50,000, whatever you are short by will be a debit balance for the day, and interest will be applied for that amount.
As I mentioned ‘not always’ for this rule, Liquid BeEs allow you to be in overnight positions in futures and options with your entire capital and you can have 100% cash equivalent for margin trading. That is, factoring in a 10% haircut, you can trade with the entire Rs 90,000 from your pledge of Rs 1,00,000 from Liquid BeEs
Conclusion
Share pledging is a useful practice that top traders and investors do to take positions in markets requiring margin without having to liquidate their existing positions. However, one must be careful as a loss in this margin could result in your broker taking away the shares you pledged as collateral.