Stock trading is a risky business. And sometimes it needs a huge amount of money.

Companies borrow money from banks to invest in projects. What if investors could borrow money and leverage the cash to buy and invest in the stock markets? 

Definition of Margin Trading

In the stock market, margin trading refers to the process where individual investors buy a big lot of shares despite not having enough funds to afford the same.

The extra fund is generally borrowed from the stockbroker.

Investors can think of it as a loan from your broker which allows them to buy more stock than they would be able to normally.

How margin trading is done?

The process of margin trading is fairly simple.

In order to proceed with margin trading, you first need to place a request with your stock broker to open a margin account.

For this, you need to pay a certain amount of money upfront to the stockbroker in cash, which is known as the minimum margin.

This would help the stockbroker recover some money by squaring off, should the trader lose the bet and fail to return the whole amount.

A margin account provides you the money to buy more quantities of a share than you can afford at any point in time. Your stock broker would lend the fund to buy shares and keep them as collateral till the time you pay the full amount. 

Once the margin account is open, before you start trading, you need to remember four important points.

  1. You need to maintain the minimum margin (MM) throughout the sessions in your account because, on a very volatile day, the stock price can fall more than one had anticipated. MM is the certain percentage of the total trading amount.
  2. You need to square off your position at the end of each trading session. If you have bought stocks, you have to sell them. And if you have sold stocks, you will have to buy them at the end of the session.
  3. Convert it into a delivery order after the trade, in which case you will have to keep the cash ready to buy all the shares you had bought during that session and to pay for the brokerage fees and additional charges like taxes.

A margin call is a broker’s demand on an investor using margin to deposit additional money or stocks so that the margin account is brought up to the minimum maintenance margin.

A margin call is issued by the broker when you have unrealized losses which are about 80% of your trading amount.

Failing to comply with these 4 points, the stockbroker will automatically square off the position in the stock market.

The percentage of margin funding may vary between 50-90%, depending on the stockbroker and his relationship with the investor.

Example of Margin Trading

Let me explain to you the concept of margin trading with this simple example.

Say you are bullish for Reliance Industries Ltd. (RIL) and believe the stock is going to pick up because of the induction of a new business line of Jio.

You want to buy 1000 shares of RIL and each share is priced at ₹800. You would need a capital amount of ₹8 Lacs to take up that position.

Assuming you have ₹2 lacs and want to get the rest of the capital to buy 1000 shares of RIL.

With margin trading, your stock broker can help you with the rest of the capital while charging you a specific interest percentage.

In the first scenario,

Your call went right and the stock price jumps to ₹900 post the announcement of Jio.

With a jump of ₹100, you were able to make a profit of ₹100 X 1000 = ₹1,00,000 without even owning the full investment capital.

So, there will be a sizable profit you will make post paying the interest, brokerage fee, and taxes.

In the second scenario,

Your call went wrong and the stock value actually came down to ₹700 after the launch of Jio.

Then, you will be making a loss of ₹100 X 1000 = ₹1,00,000

So, it needs to be understood that Margin trading is a double-edged sword and should be used only when you are completely sure of the trade trend of shares you interested in.

Advantages and Disadvantages of Margin Trading

Advantages

 

  1. The ability to leverage your investments and increase the returns when the price of your holdings is moving in an upward direction.
  2. Investors able to invest more while having limited cash on their hands and allows them to take advantage of timely market opportunities.
  3. Margin trading enables investors to diversify their portfolio by using the margin buying power if they hold a concentrated stock in the portfolio.
  4. Investors can finance to meet their personal needs without additional paperwork or fees.
  5. As long as your debt does not exceed investors’ margin maintenance requirement, they can pay back the loan back on their own schedule.

 

Disadvantages

  1. As the profit or loss is calculated on the entire traded amount, margin trading has the potential to wipe out your entire capital if your anticipation about the stocks borrowed goes wrong.
  2. If the investor fails to meet the margin call, the brokers call for immediate liquidation of stocks kept as collateral and may generate further losses to the investor.
  3. Investors have to pay high rates of interest and fee on the amount borrowed from the broker.

The Bottom Line

There is no doubt that margin trading helps budding traders and investors to make stock market transactions and investments.

But investors must also carefully pick their deals because the loss is just as much amplified as does the profit.

So, investors must evaluate their risk appetite before trading for best results even during tough times in the stock market.

Happy Investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.