Know About Margin Trading: Risks and Advantages

Margin trading is a method of investing where a broker lends you money to buy securities, allowing you to control a larger position than your own capital would permit. This leverage can magnify potential profits, but also increases the risk of significant losses. 

In this article, let's understand margin trading, how it works, its features, eligibility, requirements and much more.

Key Highlights:

• The margin trading segment should be separately activated with your broker.
• Minimum cash margin to be maintained in the demat account to cover the daily price fluctuations.
• The interest amount will be deducted from the ledger daily, including holidays.
• Shares bought on the MTF will be pledged to the broker as collateral for funding.

What is Marginal Trading

Marginal trading is a way to purchase shares in a company, in which your broker extends you credit to buy shares beyond your capital. The margin can be settled later when you square off your position. You make a profit when the profit earned is much higher than the margin; otherwise, you suffer a loss.

Features of Margin Trading

• Margin trading allows investors to leverage positions in securities, not in derivatives.
• Only authorised brokers can offer margin trade accounts as per SEBI regulations.
• Margin-traded securities are defined by SEBI and the respective stock exchanges.
• Investors can create positions against the margin in cash or by providing collateral in the form of shares.
• Margin-created positions can be carried forward for up to N+T days, where N is the number of days the position can be carried over (this varies across brokers) and T is the trading day.
• Investors wishing to use the margin trading facility should create an MTF account with their respective brokers and accept the terms and conditions, stating they know the benefits and risks involved.

Eligibility for Margin Trading

You need a margin account with the broker to avail of the margin trading facility (MTF). The margin varies across brokers. You are supposed to pay a certain sum (minimum) when opening the MTF account. 

You are required to maintain a minimum balance at all times. Your trade gets squared off if you fail to maintain the minimum balance. The squaring-off position is compulsory at the end of each trade session.

How Margin Trading Works?

Margin trading allows you to borrow funds from a broker to increase your investment size, enabling you to buy more securities than you could with your own capital. Follow the steps below for margin trading.

• Open a margin account: You must open a special margin account with your broker to use this feature. 
• Deposit the initial margin: You deposit a portion of the total investment amount yourself, known as the initial margin. 
• Activate Segment: Activate the Margin Trading Segment from your registered broker by sending a request for your account.
• Borrow funds from the broker: The broker lends you the remaining amount needed to purchase the securities, which can be a significant portion of the total value. 
  • Example: If you want to buy 100,000 worth of stock and the margin requirement is 25%, you pay 25,000, and the broker lends you the remaining 75,000.
• Pay interest: You pay daily interest on the amount you borrowed from the broker. The interest rate is typically lower for larger loans. 
• Maintain the required margin: You must continuously monitor your account. If the value of your investments drops significantly, the account equity may fall below the required maintenance margin. 
• Respond to a margin call: If your account falls below the required maintenance margin, the broker will issue a "margin call". You must either deposit more funds into the account or sell some securities to bring it back to the minimum level. 
• Close the position: When you are ready to exit the trade, you sell the securities. The proceeds are first used to pay back the loan from the broker, and you keep the remaining profit or bear the remaining loss.

Advantages of Margin Trading

• Margin trading is suitable for investors who want to profit from short-term price fluctuations but lack sufficient cash.
• Securities in the portfolio or demat account can be utilised as security/collateral.
• MTF improves the return on capital invested.
• MTF enhances investors’ purchasing power.
• The market watchdog, SEBI, and stock exchanges continuously monitor the margin trading facility.

Risks Involved in Margin Trading

Magnified Losses: 

If the margin can help investors magnify profits, it can also magnify losses. You can end up losing more than what you invested. Investors think that borrowing from brokers is simpler and that dealing with them is more straightforward than dealing with banks. But little do they know that lending through brokers is as binding as lending through banks.

Minimum Balance: 

Always maintain a minimum balance in your margin trade account. If your balance falls below the minimum, your broker will ask you to maintain a sufficient balance. If you cannot keep the minimum balance, you will be forced to sell some or all the assets to maintain the minimum balance.

Liquidation: 

Brokers can initiate action against investors who fail to comply with the margin trade agreement. If you fail to meet a margin call, the broker can liquidate your assets to recover the sum.

How to Use Margin Trading Facility Better

Invest Wisely: 

If you plan to invest through margin trading, you must be highly cautious. Margin trading can magnify both losses and profits. If things go well, then it’s okay. If things go against you, you will be in a real spot of bother. You should invest through margin trading only if you have sufficient cash to withstand a momentary move against your position and meet the margin call.

Borrowing Less than the Allowed Limit: 

You should refrain from borrowing the full limit. Give it a try with a smaller amount upfront and see how it goes. You can continue as a margin trader if you are confident you can make good profits.

Borrow for Short Durations: 

A margin is like a loan; you are liable to pay interest. Settling the margin as soon as possible is advisable to avoid incurring higher interest.

Conclusion

Margin trading is a high-risk, high-reward strategy that requires significant caution, discipline, and a well-developed plan. It allows investors to leverage borrowed funds for greater purchasing power, potentially amplifying profits, but also magnifies losses and can lead to forced liquidation through margin calls if not managed properly.