Margin trading allows investors to amplify their purchasing power in the stock market by enabling them to buy stocks beyond their current financial capacity. By borrowing funds from a stockbroker, investors can acquire shares at a marginal price rather than the full market value. This borrowed amount functions as a loan, which accrues interest over time. Margin trading offers the opportunity to achieve higher returns by leveraging the investor’s position through cash or securities, providing broader market exposure. However, it carries inherent risks and demands a precise understanding of market trends to maximise potential gains.
How margin trading works
Once Margin Trading Facility (MTF) account is opened, the broker can disburse funds in it which the investor can use to buy shares. The amount disbursed is a loan provided against the collateral of cash (minimum margin) or the purchased securities.
Suppose an investor wants to buy shares worth Rs. 1,00,000 but he doesn’t have the entire amount. However, he can pay a portion of the total amount for buying the shares. This amount is the margin.
Assume that the margin in this case was 20%. Then, the investor must give Rs. 20,000 (20% of Rs. 1,00,000) to the broker before buying, while the remaining Rs 80,000 will be lent by the broker. The investor will pay interest to the broker on the margin amount.
What are the features of margin trading in India
Here are the features of margin trading in India:
- Collateral: You can leverage cash or the securities in your portfolio as collateral to borrow money from the stockbroker to buy securities on margin.
- MTF account: Securities you buy or sell using a margin are done through an MTF (margin trading facility) account. The account and its operations are pre-defined by the Securities and Exchange Board of India (SEBI) and the stock exchanges.
- Authorised brokers: Investors can only use the margin facility through stockbrokers registered and licensed by SEBI.
- Margin increase: If the market is bullish and the stock prices are appreciating, the margin from the stock you have put up as collateral also increases. This can allow you to buy more securities on margin.
- Carry forward: While margin trading, you have the facility to carry forward your margin-bought positions up to T+N days. Here, T is the trading day when the trade is initiated, while N is the number of days you are allowed to carry forward the positions. Stockbrokers determine the days you can carry forward the positions, and the value of N varies across stockbrokers.
Advantages of margin trading
Here are the advantages of margin trading:
- Ideal for short-term profit generation:
Margin trading is beneficial for investors looking for profit-making through short-term price fluctuations in the stock market but facing a shortage of cash for investing. - Leverage market position:
Margin Trading enables an investor to buy large volumes of stock with a smaller amount and thus, amplifies their leverage. Leverage puts them in a favourable position where one can take advantage of even small market movements. But one needs to manage it cautiously as negative price movement also amplifies the losses proportionally.
Margin trade is advantageous only when the rate of return is higher on the investment than the interest on the loan. It magnifies gains as well as losses.
Suppose you have invested Rs. 50,000 in stock with anticipation of higher returns but the stock value has decreased to Rs. 45,000. You have to bear the losses as well as the payment of interest on the loan from the broker.
Margin call
Margin call takes place when a margin account balance is less than the minimum maintenance margin. Usually, a margin account goes low on funds due to a losing trade. Broker has the right to insist traders to deposit funds to maintain the minimum maintenance margin. If the trader is unable to do so, the broker can square off the order at the market price.
Risks involved in margin trading
Here are the risks involved in margin trading:
- Magnified losses
Margin trading can help boost returns but on the other hand, it magnifies losses as well. It can lead to the loss of the entire invested capital as well. - Minimum balance
Investor needs to maintain a minimum balance in the margin trade facility account. This means a portion of their capital is always locked in. If the account balance depletes below the minimum required balance, the broker will insist the investor to maintain the minimum balance by adding cash or selling a portion of their holdings. - Liquidation
Investors must abide by the rules associated with using the margin trading facility. For example, if an investor has taken a position through margin trading and the trade is going bad, leading to the balance falling below the minimum margin, then a margin call is triggered. If the investor does not honour the margin call, the broker can square off the position and liquidate the assets.
What are some of the margin trade practices to remember?
Engaging in margin trading necessitates vigilance due to its potential for both substantial gains and significant losses. To manage these risks effectively:
- Understand margin calls: Be prepared to respond to margin calls, which occur when the account’s equity falls below the required level.
- Avoid over-borrowing: Limit the amount borrowed from the margin trading facility (MTF) to reduce exposure to high-interest obligations and financial strain.
- Manage interest accumulation: Recognise that the borrowed funds are subject to compounding interest, emphasising the need for strategic borrowing and timely repayment.
By approaching margin trading with caution and discipline, investors can harness its advantages while mitigating associated risks.
SEBI regulations regarding margin trading
SEBI has implemented new margin rules to bring transparency and safeguard the interests of investors. Some of the key points are as below:
|
Before |
Now |
Initial margin required in cash segment |
No |
On T day, Minimum 20% margin required, for margin reporting |
Initial margin required for selling of shares |
No |
Minimum 20% initial margin required even while selling of shares. To avoid initial margin, Broker will do early pay-in |
Penalty on short margin |
No |
Yes |
Pledging of shares |
To pledge shares to obtain margin, the investor has to transfer the shares to the broker's account or give Power of Attorney to Broker |
The shares will remain in the investor's Demat Account and limit on shares given as collateral will be available only on shares which are provided as margin through Margin Pledge Mechanism. |
- The new norm necessitates the maintenance of an upfront margin at the beginning of the trade.
- For the Equity Derivatives segment, the client margins which are required to be compulsorily collected and reported include initial margin, exposure margin/ extreme loss margin and mark to market settlements.
- For BTST (Buy Today, Sell Tomorrow) trades upfront margin will be applicable on both legs (i.e., Buy and Sell).
Besides upfront margin requirements, the rule of peak margin reporting has commenced from 1st December 2020 apart from the end-of-the-day margin check, which captures the highest open position of the trader on a given day.
This means a trader necessarily will have to maintain an upfront margin without fail else a penalty will be imposed.
The best way to remain safe from any kind of penalty in margin trade facility, investors should contact their brokers to know about margins while executing a trade.
Tips and strategies for margin trading
Here are some tips and strategies for margin trading:
- Evaluate your risk appetite and investment goals: Evaluate how much risk you can take while margin trading. It will help determine the amount you want to borrow using the margin trading facility. Furthermore, define your trading goals, whether they are short-term profits or long-term investments. Having clear objectives will help you make better trading decisions.
- Start small and educate yourself: It is always wise to start small at the beginning, as there are more chances of losses because of no margin trading experience. Use a small amount and analyse the results to gradually increase the amount based on experience. Meanwhile, read about market analysis, technical and fundamental indicators, and risk management techniques for a better margin trading approach.
- Manage risks: Trading on margin is risky as the stock market is volatile. Hence, it is important to diversify your investments across multiple assets to ensure any losses are offset by gains from other investments. Furthermore, you can use orders such as stop orders and limit orders to limit your losses and protect your capital.
- Conduct thorough research: It is of the utmost importance to conduct in-depth research of securities you are considering buying through margin. Analyse chart patterns, historical prices, company fundamentals, affecting technical indicators, current market trends, etc., to ensure that your investments will increase in price, mitigating the chances of losses.
- Monitor your trades regularly: One of the most important strategies while margin trading is to monitor your investments regularly. The stock market fluctuates in real-time and this can significantly affect the value of your investments. By regularly monitoring your investments, you can make real-time adjustments to book profits or limit losses.
- Avoid over-leveraging: It is true that buying on margin can be a great way to make better profits, but it can also lead to higher losses if the trades become unfavourable. Hence, avoid over-leveraging and borrow within your means based on your risk appetite. Don’t be greedy for over-the-top profits; cut your losses if you feel your trades are going down in price.
Conclusion
Margin trading is a unique facility where stockbrokers lend money to investors to let them buy securities worth more without having to use their money. It can allow investors or traders like you to amplify your gains by borrowing money from stockbrokers based on the total value of the securities held in the margin account.
However, as the stock market is volatile, margin trading can be risky as it can lead to significant losses if the purchased securities fall in price. Hence, it is vital that you buy on margin only after determining your risk appetite, and assessing your financial situation and investment goals. It is also wise to learn about margin trading and analyse the securities extensively before executing a margin trade.
Now that you know what is margin in the share market and the process of margin trading, you can make better-informed investment decisions.
