What does Haircut means in Stock Market terms?

A haircut is a term referring to price spreads and the market value of assets. Almost all assets have a spread between the buy and sell price and this is one of the meanings of haircut.

The other meaning of the term haircut is how much an asset is reduced in value for calculating collateral levels. This is used as a buffer because there is a risk that the collateral behind an asset will devalue in the stock market, and the haircut is meant to take this into account.

As explained by Investingport, Haircut in investments or in stock trading is a term commonly used when trading stocks.    For example, stock AYZ will have a selling price, and it will also have a bidding price. This means that because a stock is priced at a certain price, it does not mean that people would not want to pay less.    

Case study: When planning to invest in the stock market, the stock  AYZ may be priced at $ 45.54, but a buyer may decide that it's worth $45.00, and the buyer will bid $45.00.  The buying and the selling price spread is what's referred too as Haircut. 

Haircut as explained by Investingport. Keep in mind that the term 'Haircut' can be used in many scenarios. 

What is a Haircut?

A haircut refers to the percentage difference between the market value of an asset and the amount that can be used as collateral for a loan. A difference exists between these values because market prices change over time, of which the lender has to accommodate. For instance, if I need a loan of $25,000 and decide to use my property that is worth $25,000 as collateral, there is a possibility that the bank would recognize the $25,000 property as worth only $12,500 in collateral. Therefore, this $12,500 or 50% reduction in the value of the asset, for collateral purposes, is referred to as the Haircut.

A Haircut sometimes is also referred to as the market maker's spread. The market makers can transact with razor-thin spreads and low transaction costs, and then can take small slivers or haircuts of profits (or losses) constantly throughout the day.

In pledging collateral, the degree of the haircut is determined by the amount of associated risk to the lender. The risks are variables that may affect the value of the collateral in a situation where the lender has to sell the security due to a loan default by the borrower. These variables include price, volatility, the credit quality of the asset's issuer, and liquidity risks of the collateral.

With technological advancement and market efficiency, spreads in many assets have dropped to the level of Haircut. Retail traders can transact at the same spreads market makers do, however, retail traders costs are still higher which may make trading the spread ineffective. 

How the Haircut Amount is Derived

Often, price predictability, as well as the lower associated risks lead to compressed haircuts, because the lender is always very certain that the full amount of the loan can be covered if the collateral must be liquidated. For instance, in the U.S., Treasury bills which are often seen as safe, can be used as collateral for overnight borrowing arrangements between government securities dealers, and are termed repurchase agreements (repos). In this case, haircuts are negligible due to a high level of certainty.

Volatile securities that are associated with price uncertainty have larger haircuts when used as collateral. For instance, an investor who wants to borrow funds from a brokerage by posting equity positions to a margin account to be used as collateral can only borrow 50% of the value of the account due to the lack of price predictability. This places the haircut at 50%. Even though a 50% haircut is standard for a margin account, a risk-based haircut can be increased if the deposited securities pose liquidity or volatility risks. For example, the haircut on a portfolio of leveraged exchange-traded funds (ETFs), which are highly volatile, may be as high as 90%. 

How Haircuts are used by some institutions

In the U.S. Securities and Exchange Commission's net capital rule, Haircut is used as a reference to valuation discounts. The net capital rule was adopted to safeguard public investors by setting standards of financial responsibility to be met by stock-dealers and requires that these stock dealers have enough liquid assets to cover current indebtedness.

The European Central Bank applies a haircut to all securities offered as collateral, and the size of the haircut depends on how risky and liquid the security offered as collateral is.

The Long Term Capital Management (LTCM) experienced losses and sought for massive bailouts in 1998. Before then, it usually got next-to-zero haircut as its trades were considered safe by lenders.

In stocks, options or futures, Haircut is used interchangeably with the term margin.