What is pledging of stocks? The pandemic brought increased participation of Indian citizens in the stock markets with a new breed of traders and investors. Now every trader and investor wants to earn above-average returns. Some even resort to margin trading facilities, collateral margins, or loans against shares. All these concepts mean the same thing more or less: borrowing funds by pledging the stocks. So, what does pledging stocks mean? Through this article, we’ll learn just that.
What is The Pledging of stocks?
Pledging of stocks is a mechanism by which investors (or traders) borrow money by providing the stocks or shares held by them as collateral. In the most simple terms, pledging means borrowing money against stock holdings. Just like stocks, ETFs and mutual fund units can also be pledged to avail loans.
What are the different ways of pledging stocks?
There are broadly three ways in which you can pledge your shares:
1. Loan against securities (LAS) means borrowing funds by pledging your shares to various NBFCs such as HDFC, Kotak, etc. Zerodha also allows you to get LAS with the help of its NBFC-arm Zerodha Capital Private Ltd.
This is usually a cheaper option as compared to taking a personal loan. During LAS, the balance gets transferred directly to the bank account.
2. Margin Trading Facility (MTF) allows one to borrow funds while making a fresh purchase itself. In the most simple terms, you can purchase a share of Rs 100 but pay only Rs 25 while taking the trade if the allowed margin is 25% on the stock. The balance amount is borrowed and interest is levied on it.
The shares are pledged to depositories after making the transaction. In this method, the stocks held have a trigger price. If the trading price falls below the trigger price, some units get sold automatically to make up for the margin shortfall. This is known as margin call. You’ve to provide more funds to avoid margin calls in situations when the stocks fall (or the position goes against you).
3. 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 changes, exchanges allow a maximum of 50% margin only to be used for F&O positions. This means if you use margin for open positions, you’ll have to fund the balance 50% requirement in cash or cash equivalents.
How much can you borrow by pledging shares?
When shares are pledged, investors get a margin (or funds) after a certain amount is deducted from the price of the collateral. The amount deducted is called a ‘haircut’.
The haircut % and the maximum amount of money you’ll get differs according to the stocks pledged. On some stocks, you can avail yourself of as much as 85-90% of the value. On others, it can be as low as only 10 to 20% of the value of your stock.
For example, assume you hold a share of Indian Oil Corp. and its present value is Rs 100. The haircut on IOCL’s share is 25%. Then you’ll get Rs 75 after pledging the share of the company in your account.
The collateral constraint is most in a loan against securities. RBI allows a maximum of 50% of the collateral value as a loan against securities. Thus if the price of a share is Rs 100, the most you can get is Rs 50. There is a multitude of charges such as processing fees, pledging fees, and more that must be closely studied while taking a LAS.
How do pledging stocks work?
Every time a pledge is created on a stock, it has to be authorized via CDSL or NSDL. The stocks (or securities) pledged are kept safe with the broker while they provide you with the money for trading or investing.
The value of the security against which a pledge is created is calculated as a lower of the previous closing price or the last trading price. After the haircut deduction, the balance starts reflecting in the available margin section of your stock broker.
The other way is you can make a fresh purchase by purchasing a share for Rs 100 on margin by paying only Rs 25. The balance amount is provided by your broker.
What are the charges for pledging stocks?
Usually, an investor has to pay the interest on the amount borrowed and a basic fee for pledging & unpledging of the stocks. Different trading platforms have different charge structures for availing of the margin facility.
- Interest charge: The interest charge levied on the borrowed funds is ideally between 8% to 18% (annualized).
- Pledging fee: This is a small flat amount usually in the range of Rs 20 to Rs 30 plus GST for every stock pledged. So the amount will be, say Rs 30 * 3 = Rs 90 plus GST if you pledge shares of three companies. The booking platforms charge this during the pledging or the unpledging process.
What are the risks while pledging stocks?
While the prospects of earning superior returns by leverage are lucrative, it also entails the risk of a margin call.
You see, the price of securities fluctuates because of the volatility. 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 avail more margin is entirely onto the trader or investor. But one must read all the terms & conditions and applicable charges carefully before pledging the shares. Furthermore, it is beneficial to compare the interest charge across the brokers to see which suits you best.
What are your views on the pledging of stocks? Which broker do you think is best for this? How about you let us know in the comments below?
Vikalp Mishra is a commerce graduate from the University of Delhi. He likes to write on finance, money and business. He is a voracious reader with a genuine interest in investing. Drop him a mail at [email protected].
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