- Date : 19/08/2021
- Read: 8 mins
Margin trading increases your purchasing power, but it can lead to magnified losses if things don’t go your way.
Consider the following scenario: you are at the racecourse and have bet Rs 2000 on a horse that you feel is a winner, but you are running short of cash. So you decide to borrow the rest of the money against some form of collateral, say your expensive watch.
If this scenario were to play out in the stock market, the brokerage firm you deal with would be the person who lends you the money to bet more, while the funds in your Demat account with the brokerage would serve as collateral against what you borrow.
This collateral is called margin or margin money, and what plays out is called margin trading.
What is margin trading?
Technically, margin trading refers to the process of trading where an individual invests more than they can afford to by borrowing cash from a broker to purchase more stock.
The minimum (marginal) amount the person must keep as collateral with the broker can be either in cash or securities. It is only a percentage of total trade volume involved, and the amount has to be cleared with the brokerage and paid up before the trade is executed.
Also, the investor can take back the collateral stocks at any point if they do not want to avail of the margin any longer.
This practice of buying on margin allows investors to purchase more stock than what they would be able to buy with just the funds in their accounts; in other words, their buying capacity increases.
An example of margin trading
Let us assume you have investible funds of Rs 10,000. In normal trading, you can only use that amount to purchase shares. But with margin trading, you can have access to more funds – say Rs 150,000, the extra amount being lent by your brokerage. This means you can buy more shares.
Moreover, investors don’t even have to spend their original amount; they can invest Rs 5000 of their own cash, the rest coming as borrowing. It is possible for an investor to make more profit with margin trading than in normal trading.
The loan must be repaid with interest, as charged by the broker. This also means that for investors to make a profit, the returns have to be more than what is paid out in interest. (See 'How much interest is charged?' below)
However, there is one condition with margin trading: the shares have to be sold off/bought back the same day these have been bought/sold. This is called ‘squaring off’, and it has to be done before the trading hours end.
This also means that if the stock value falls below the purchase price before trade closes, the investors lose money if they are selling, and make profits if they are buying.
How is margin calculated?
When shares are used as collateral, they are generally devalued in order to provide a safety cushion to the broker in case the market price of the pledged scrip falls.
The quantum of the markdown is called ‘haircut’. For example, if you want to keep stocks worth Rs 1 lakh as collateral, the broker may deem the pledged portfolio as worth only Rs 50,000; this is a 50% reduction in the value of the asset.
This 50% reduction is called ‘haircut’ in stock market parlance. It is expressed is in percentage and covers the broker’s risk in case the collateral share price begins to fluctuate. Stock exchanges prescribe standardised haircuts for various stocks; these remain the same for all brokers for any particular scrip.
It is the haircut assigned to the equity share you want to pledge that allows the margin amount to be calculated. For example, if your collateral is Reliance Industry shares with the haircut at 20%, it would mean you will be entitled to a loan up to 80% of your Reliance shares.
How does margin trading work?
If you want to buy stocks on margin, you need to a special margin trade account, or margin against shares account, or simply margin account, with a brokerage authorised by the Securities and Exchange Board of India (SEBI).
This is a special type of standard brokerage account, where the broker lends you the money to buy more securities than what you could have afforded with what is actually deposited in your account.
The margin account is different from your Demat account. This is how it works: you transfer your shares from your personal account to your broker’s beneficiary account, who then moves those shares to your client’s margin account.
After availing of a loan, you can hold it for as long as you wish, but you have to pay interest on it (this shall be discussed later). There may be other obligations to meet – for example, commissions to be paid on a trade – but this depends on the broker.
Also, in case you sell any stock, the broker may lay claim on the proceeds to recover any pending loans. Furthermore, you must have a minimum account balance in your margin account, as per the broker’s requirement.
This minimum balance (called the maintenance margin) must be maintained at all times. The broker is at liberty to sell off assets in your margin account if you cannot maintain the minimum balance.
Please note that margin trade is allowed only in the case of securities predefined by SEBI and the respective stock exchanges. The regulator and the exchanges monitor all transactions.
Also, mutual fund units cannot be bought through margin trading, as they are not sold like stocks, but bought and redeemed through mutual fund houses, with fund prices determined only after market closing on a working day.
How much interest is charged on margin trading?
In India, interest rates for loans against shares vary across different stocks and hover between 15% and 18%, though brokers may also charge a daily rate, say around 0.05%. However, it is advisable to check with your broker at the outset.
The rate quoted depends mainly on the quality of the stock you would like to invest in. Sometimes, the client’s relationship with the brokerage also comes into play. For instance, active day traders may be courted with cheaper rates.
The state of the market may also become a deciding factor, with brokers increasing the interest rates in uncertain times when there’s a greater risk of default.
In addition to the interest payouts, brokerages may also claim a small commission on trades where margin funding has been used. These charges depend on the volume of the trade.
Benefits and risks of margin trading
You can both benefit and face problems with margin trading. Let us start with its advantages.
The first advantage is that it allows you to cash in on price fluctuations over the short term when you do not have enough cash in hand. Under this, they can take stock delivery on paying a part of the total amount, with the broker paying the remaining amount.
Apart from this, margin trading also has other advantages, as listed below:
- It allows you to utilise securities lying idle in your portfolio or Demat account as security/collateral;
- It improves the rate of return on your invested capital, because the borrowed money allows you to invest more capital, and this increases your chances of making more profits.
- It enhances your purchasing power.
But as stated earlier, if margin trading helps you make bigger profits than you would have made in normal trading, it can also entail bigger losses; do not expect debt write-offs because even if you make losses, you are by law bound to pay off the borrowed amount.
If you fail to meet your loan repayment obligations on time, or if the minimum balance falls below the required level, your broker can take what is known as a ‘margin call’, whereby you can be forced to deposit fresh funds or sell your stocks to either to repay your debt or to bring the balance to the desired level.
If you fail to respond to a margin call satisfactorily, the brokerage can legally sell off your stocks.
Choosing the right broker for margin trading
Choosing a brokerage house that meets your needs can be difficult as different brokerages offer different benefits to traders. Some may charge a higher commission but offer more intraday leverage, while others charge less but are not as liberal with such leverages.
You have to draw a balance between intraday margins offered and commissions asked for when choosing a broker to open your margin account with.
As margin trading can enhance both your losses and your profits, you have to be very cautious when taking this investment route. Go for it only if you have sufficient cash to meet a margin call (if there ever is any). Moreover, avoid using up your entire borrowing limit, or delaying settling the margin; these only add to the interest burden.