In today’s world, where the market fluctuates at each changing second, we have ample opportunities to earn gains out of these fluctuations. We could earn out of the market even when we lack liquidity. Margin trading is one of those methods.
Diving into a vulnerable business method like margin trading requires a plethora of information and plenty of tips and tricks.
Let us proceed ahead and grab the basics of them!
Some key terms relating to margin trading are as follows:
A margin account is a type of brokerage account in which the broker puts in the money with which the investor (borrower) can purchase stocks in the market, keeping a minimum margin requirement in possession.
A margin call is a call by the broker (lender) to the borrower when the amount in the margin account falls below the minimum margin requirement.
In case of any defaults, the broker has the legal right to sell all of the shares of the investors and cover up his/her margin loan amount.
A minimum margin requirement is the necessary amount of money that the investor is bound to keep in the margin trading account.
Margin trading refers to the trading process where an individual increases their potential return on investment by investing more than they can afford. Here, investors can benefit from the opportunity to buy shares at a marginal price of their true value. Such trading transactions are financed by brokers who lend investors cash to buy stocks. Margin can be settled later when investors liquidate their position in the stock market.
In this regard, margin trading gives investors access to higher capital for investment, thereby helping them to leverage their market position, either through security or cash. Subsequently, this trading helps to increase results so that investors can get higher profits from successful trades. However, this trading can be quite risky and the investors only get profit when the total profit is more than the initial margin.
Until recently, margin trading in India was only allowed through cash, while the provision of shares as collateral was restricted. However, as per the new regulations issued by SEBI In 2018, investors can leverage their market position through margin trading by providing shares as collateral.
Further, margin accounts can only be offered by authorised brokers under the regulations issued by SEBI.
Those who wish to invest through margin trading can do so by creating a Margin Trading Facility (MTF) account with their brokers.
An MTF account is a type of brokerage account where the authorised broker disburses the funds to the investor to buy shares or other similar financial products. As in usual with margin trading, borrowing on MTF accounts can be used against the collateral in cash (also known as minimum margin) or securities purchased and come with an interest rate charged periodically.
When an investor buys securities through funds in the MTF accounts and the value of these securities is increasing above the interest rate charged on them, then the investor
enjoys higher returns than they would have if they had invested in the securities with only their funds.
However, on the other hand, the broker charges interest on the funds in the MTF accounts for as long as the loan remains outstanding, thereby increasing the investor’s cost of purchasing the securities.
As a result, if the securities do not appreciate and rather fall in value, the investors will suffer losses in addition to having to pay the interest on the margin funds to the brokers.
The following is an example of margin trading that illustrates how this process works:
Suppose Mr Sharma buys shares for Rs. 100, and when squared off, the price of this stock rises to Rs. 112. If he had bought the shares through the cash he had and paid for them in full, Mr Sharma would have earned a 12% return on his investment.
On the other hand, if he buys this stock using margin trading and pays only Rs. 40 in the cash segment, he will get a 72% return on the money he invested.
Margin trading thus allows investors to earn a lot higher return on investment.
On the other hand, if the share price falls, the investor may also suffer insurmountable losses. For example, the value of the shares bought by Mr Sharma falls from Rs. 100 to Rs. 50. If he had bought these shares entirely in cash, he would have suffered a 50% loss on his investment. But if he buys stock through margin trading, he will have a loss of more than 100%.
There is also an e-margin trading option that allows investors to buy shares by simply paying 25% to 45% of the total amount. This tool allows investors to pay the remaining amount at a certain pre-agreed interest rate. For example, if you want to buy 100 shares of company A and the current price of one share is Rs 500, then you would have to have a total amount of Rs 50,000 plus the required amount for the brokerage to continue.
However, in the case of e-Margin, you can buy these shares by paying only 25% of the total delivery amount, and the remaining 75% of the margin amount will be provided by the broker. This margin amount is then collected with predetermined annual interest.
Hence, from the above example of margin trading, we can understand that this process can bring investors either high profits or significant losses, depending on how stocks work in the market.
The benefits of this business process can be summarised as follows:
Margin trading is ideal for investors who want to profit from short-term price fluctuations in the stock market, but do not have enough money in hand to invest.
This trading process helps investors to use their positions in securities that are not from the derivatives sector.
It allows investors to maximise the rate of return on the capital invested.
Investors can use securities in their Demat account or their investment portfolio as collateral for margin trading.
Margin trading facility is under constant supervision of stock exchanges and SEBI.
While investors can increase their profits from margin trading, it can also be risky for several reasons. Following are some risks associated with margin trading.
The risks associated with margin trading are high as investors may end up losing more than they invested.
Investors must maintain a minimum balance in their MTF account at all times. If the balance falls below what is mandated by the broker, the investor will be forced to put in more cash or sell some shares to maintain the minimum balance.
Brokers have the right to liquidate assets in the MTF to recoup their losses if investors do not live up to their end-margin trading agreement.
However, investors can minimise the chances of losses from this trading by applying the following practices:
Therefore, investors must gauge their risk appetite before deciding on margin trading for investments.
Margin and leverage differ from each other on several factors. To ease the understanding of the matter, we have provided an all-encompassing comparison chart between margin and leverage.
Serial No. | Basis | Leverage | Margin |
1. | Definition | Leverage is a kind of debt that the broker lends. Leverage means trading more than the actual capacity and affording a lot more with the help of margin loans. | Margin is the minimum amount that the borrower has to keep to get a loan, and it is a mandatory obligation on the part of the investors. |
2. | Type of investment | Leverage is a great investment tool that can mobilise small investments into greater profits with market fluctuations. | Margin is an obligation of two types:
Initial margin and maintenance margin. Initial margin is the deposit required on the opening of a margin account, and maintenance charges are the charges for keeping the margin account in active usage when incurring losses. |
3. | Kind of security | It is primarily a kind of debt. | It is primarily a type of collateral security. |
The features of margin trading and the facilities provided by it are as follows:
Margin trading is a riskier idea, and accomplishing it without any information and experience might lead to fatal debt conditions or even insolvency. It is suitable for experienced investors and those who are well-versed or able to bear the risk.
When margin trading is executed properly, profits can be made on an extensive basis due to increased buying power. However, if any faults arise, the investors can lose more than the original investment.
By now, it’s clear that margin trading is not for beginners!
During a cash trade, a loan is sanctioned, and purchases can only be made with cash. Securities cannot be used as collateral. However, margin trade is the trade in which purchases can be made with securities of any type as collateral.
The margin account might get restricted, and the securities bought with the loan money can be taken over by the broker. Several options from the margin account might also be removed.
Securities of a type that can be used for margin borrowing are as follows:
While these securities cannot be used for margin borrowing:
One should be fully aware of the trading risks and a well-knit concept of leverage risk and margin risk. Ensuring the minimum margin balance is essential to avoid margin calls. In case of defaults, assets and securities can be sold by the broker anytime.
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