In this article, we will discuss
- What is Margin Trading?
- Key Features of Margin in Share Market
- Example of Margin Trading
- Different Components of Margin in the Share Market
- What Is the Meaning of Margin Call?
- Advantages of Margin Trading
- Risks of Margin Trading
- Should You Invest In Margin in the Share Market?
- How to Minimise Risk in Margin Trading?
What is Margin Trading?In simple words, margin trading is a stock market feature that allows traders to purchase more shares than what they could otherwise afford to. Think of it as a loan from your stockbroker. You put a certain amount as a down payment, and you borrow the balance from a bank to afford the shares. In margin trading, you put down a certain amount of money upfront, and your stockbroker funds the rest. The money you put upfront is called the margin, and for the remaining amount you borrowed, your broker levies a periodic interest on the same. This margin is settled when you square off your position. To make profits, your net profit must be higher than your margin value, or you would end up with losses otherwise. Previously SEBI permitted traders to only use cash for margin trading. However, in 2018, it also allowed traders to pledge their securities as margin. Therefore, if you have any shares or securities in your demat account, you can put up a pledge request with your stock broker. Once the request successfully carries through, your broker will lend you the funds to leverage your margin in the share market.
Key Features of Margin in Share MarketHere are some of the important points to keep in mind before you carry out a margin trade.
- Any trader who wants to carry out margin trading will first have to open a Margin Trading Facility (MTF) account with their brokers. This is the account where your broker will credit funds for margin trading.
- The margin requirement varies with different brokers. When you open your MTF account, you will be required to pay a certain sum of money for the same.
- A Margin Trading Facility can only be offered by authorised brokers. Hence, it is very important for every trader to conduct thorough research before creating an MTF account.
- The securities that are eligible for margin trading are pre-defined by SEBI and the stock exchanges. So make sure to check them as well before opening an MTF.
Example of Margin TradingNow that you have a basic idea of what is margin, along with some of its relevant features, let’s take up an example to understand it better. Suppose you have ₹10,000 in your MTF, and you want to buy stocks worth ₹20,000 trading at₹100 per share. Now if you take a loan from your stockbroker, you can easily buy shares worth ₹20,000 for just ₹10,000. Here your account balance would still reflect ₹10,000, but your stocks would reflect a value of ₹20,000. Further, if the price of the share moves up to ₹ 120 per share, your account balance would be ₹14,000 after deducting the value of the margin loan. This means you gained a 40% profit on your stocks with just a 20% increase in its price. However, because it is a two-way street, the situation can also be reversed. So, if the stock price fell by 20% and came down to ₹80 per share, the value of your shares would come down to a total of ₹16,000. At this point, your account balance would be ₹6,000. This means you would face a loss of 40% with just a 20% decrease in the price of securities.
Different Components of Margin in the Share MarketThere are mainly three types of margins you must be aware of before making a margin trade or even opening a margin account.
What Is the Meaning of Margin Call?As soon as your stockbroker realises that your account value is dropping below the maintenance margin, they will ask you to add more funds to keep your trade open. The broker can try to contact you via calls or emails to add the requisite funds. However, do remember that a broker is not liable to make any margin calls to remind you to add more funds. Additionally, if you fail to meet the maintenance margin, the brokerage firm will sell your share to meet this requirement. Now if we take the scenario of loss from the above example, you would see the account value is already at ₹6,000. Depending on your broker, they may or may not make a margin call, but you would still be required to meet the maintenance margin if the value goes below ₹6,000. If you fail, the stockbroker will sell securities on its own without waiting for you to meet the margin requirement.
Advantages of Margin TradingMargin trading has proved to be a major source of profits for many investors. Here are some of the key benefits of trading on margin in the share market.
- It is one of the best alternatives for traders looking to leverage short-term profit opportunities in the market but lack sufficient capital for the same.
- Investors get an opportunity to gain maximum returns in a given situation with limited capital. They can make more profit with margin trading as compared to common trades.
- Traders who do not have sufficient funds to contribute even towards the initial margin can also pledge the securities they own. This relieves them from the compulsion of having to possess funds to trade in the market.
- SEBI has made several provisions to ensure that the entire process of margin trading is transparent. This ensures the safety of a trader’s funds and securities.
Risks of Margin TradingLeveraging margin to make profits in the market may sound quite tempting. However, there are several risks associated with it. It is crucial for an investor to be aware of them before deciding to margin trade.
- Margin trading carries a high risk of losses. If the market trend goes against your strategy, you can end up losing your entire capital. Additionally, you will still be liable to pay interest and other charges on the borrowed funds.
- If you do not have sufficient funds to keep the maintenance margin, the broker can square off your position. The firm won’t take into consideration your viewpoint of future predictions. You will just end up losing more than you could afford.
- You are liable to pay interest on the borrowed funds. Hence the longer you keep your position open, the more interest you pay.
- It is very rare to predict accurate timings in the market. Hence in certain situations, irrespective of how careful you are, you can still end up at a loss.
- Sometimes even the most seasoned investors end up incurring losses on a margin trade; hence, it is not suitable for novice traders.
Should You Invest In Margin in the Share Market?Before you make the big decision to open a Margin Trading facility, there are certain parameters you should take into consideration. If you think they are in your favour, then you can consider margin trading.
Your knowledge of the market:
How to Minimise Risk in Margin Trading?While it is impossible to completely eliminate the risk from margin trading, you can take certain measures to minimise it. Here are a few suggestions you can follow:
- Always have some surplus cash in your margin account. This would prevent your broker from forcefully squaring off your position to meet the maintenance margin.
- Always set your maintenance margin higher than your brokerage firm. This would prevent you from reaching the broker threshold as you will get some time to infuse more cash into your trade.
- Since interest charges are computed on a compounding basis, make sure to pay your interest regularly.