Margin trading refers to the process of trading where an individual increases his/her possible returns on investment by investing more than they can afford to. Here, investors can benefit from the facility of purchasing stocks at a marginal price of their actual value. Such trading transactions are funded by brokers who lend investors the cash to purchase stocks. The margin can later be settled when investors square off their position in the stock market.
In this respect, margin trading provides investors with access to higher capital for investment, thus helping them to leverage their position in the market, either through security or cash. Subsequently, this trading helps to boost results, so that investors can earn higher profits on successful trades.
However, this trading can be quite risky, and investors can earn a profit only when total profit earned is higher than the margin.
In this article
SEBI Regulations Regarding Margin Trading
Up until recently, margin trading in India was allowed only through cash, while providing shares as collateral was restricted. However, under fresh regulations put forth by SEBI in 2018, investors can leverage their market position through margin trading by providing shares as security.
Further, margin accounts can be offered only by authorised brokers, according to regulations put forth by SEBI.
How can Investors Partake in Margin Trading Process?
Those wishing to invest through margin trading can do so by creating a Margin Trading Facility (MTF) account with their brokers.
MTF account is a type of a brokerage account where the authorised broker will disburse funds to an investor to purchase stocks or other such financial products. As is the norm with margin trading, the loan in MTF accounts is availed against collateral of cash (also known as minimum margin) or securities purchased, and come with an interest rate levied periodically.
How does Margin Trading through MTF Work?
When investor purchases securities through the funds in the MTF accounts and the value of these securities increase over the rate of interest charged on them, then the investor enjoys higher returns than they would have if they had invested in securities solely with their own funds.
However, on the other hand, the broker charges interest on the funds in 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 decline in value, investors will suffer losses on top of having to pay the broker interest on margin funds.
Following is a margin trading example that illustrates how the process works –
Mr Agarwal purchases a stock for Rs. 80 and while squaring-off, the price of this stock rises to Rs. 90. Had he purchased the stock through the cash segment, and paid for it in full, Mr Agarwal would have earned a 12.5% return from his investment.
On the other hand, if he purchases this stock through margin trading and pays only Rs. 30 in the cash segment, he will earn a 75% return on the money he invested.
Margin trading thus makes way for investors to earn a much higher return on investment.
On the other hand, if the price of the stock falls, the investor can also incur insurmountable losses. For instance, the value of the stock Mr Agarwal purchased falls from Rs. 80 to Rs. 40. If he had purchased this stock entirely through cash, he would have incurred a 50% loss on his investment. But if he purchases the stock through margin trading, he will incur a loss of more than 100%.
There is also the option of e-margin trading which allows investors to buy stock delivery by just paying 25% to 45% of the total amount. This facility allows investors to pay the remaining amount at a certain pre-agreed interest rate. For instance, if the investor wants to buy 100 shares of Company A and the current price of one share is Rs 500 , then you would be required to have a total amount of Rs 50,000 plus the necessary brokerage amount to proceed. However, in case of e-Margin, you can buy these shares by paying just 25% of the total delivery amount and the remaining 75% margin amount is provided by the broker. This margin amount is then levied with 18% per annum interest.
Thus, from the margin trading calculation illustrated above, it is evident that the process can either bear high profits or substantial losses for investors, depending on how the stocks perform in the market.
Advantages of Margin Trading
The benefits imparted through this trading process can be summarised as follows –
- Ideal for short term profit generation –
Margin trading is ideal for investors looking to profit from short term price fluctuations in the stock market, but not having enough cash in hand for investing.
- Leverage market position –
This trading process helps investors to leverage their position in securities that are not from the derivatives sector.
- Maximise returns –
It allows investors to maximise the rate of return on the capital they invest.
- Utilise securities as collateral –
Investors can utilise the securities in their Demat account or their investment portfolio as collateral for margin trading.
- Regulated under SEBI –
The facility of margin trade is under constant supervision of stock exchanges and SEBI.
Risks Associated with Margin Trading
Even though investors can magnify their profits from margin trading, it can also pose to be a risk for several reasons. For instance –
- High risks –
The risks associated with margin trading are high as investors can end up losing more than they had invested.
- Minimum balance maintenance –
Investors have to 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 deposit more cash or sell off some of the stocks in order to maintain the minimum balance.
- Risks of liquidation –
Brokers have the right to liquidate assets in the MTF to recover their losses if investors fail to uphold their end of the margin trade agreement.
However, investors can minimise chances of losses from this trading by exercising the following practices –
- Since investing through margin trading is akin to borrowing an advance, investors are liable to pay a certain percentage of interest on it. That is why it is crucial for investors to try and settle the margin at the earliest to avoid accumulating a large interest on it.
- Investors should be careful and refrain from borrowing the maximum amount allowed. It is best to continue margin trading once investors are confident about making profits.
- Since this trading process can bear both high profit and loss, investors should ensure that they have sufficient cash to meet the margin, should the market become unfavourable for them.
It is thus crucial for investors to gauge their risk appetite before deciding to pursue margin trading for investment.