What is Margin Trading? Risks and Advantages

You heard news that is expected to swing up the share price of a company in near future. You wish to buy 100 shares of that company right now & hold it for a month, but your available fund only allows you to buy 30 of them. Is there a way you can buy all 100 shares right now?

Yes, through Margin Trading.

Margin Trading is the process of trading in which an investor can buy more stocks than he can afford with the funds that are available to him at the moment. In this, he is allowed to buy stocks by paying a marginal amount of the actual value. To avail of the Margin Trading Facility, or Margin Trade Funding (MTF), the investor needs to request his stockbroker to open an MTF account. A minimum balance (known as the minimum margin) has to be maintained in the margin account. This is specified by the broker. Before trading, the investor is required to deposit a certain percent of the total traded value, and the rest is funded by the broker. The broker charges an interest rate on the funded amount.

How Does Margin Trading Work?

After the opening of an MTF account, the broker can fund client’s trade once client places an order under MTF & pays the required margin. The funded amount is like a loaned capital that the investor will pay interest on.

Example : An investor wishes to purchase shares worth Rs 50,000 but he doesn’t have the full amount. He can pay a part of the total amount to buy the shares, called margin.

Suppose the margin, in this case, is 10%. So, the investor pays Rs. 10,000 (10% of Rs. 50,000) to the broker prior to buying and the remaining amount would be lent by the broker. The investor is required to pay interest to the broker on the lent amount.

Advantages of Margin Trading

  • It’s ideal for an investor looking to make a profit through short-term price fluctuations in the stock market but doesn’t have enough cash in hand.
  • MTF helps in enhancing the investors’ purchasing power.
  • Securities in the Demat account /portfolio could be utilized as a security/collateral to pay the margin.

Eligibility for Margin Trading

As an investor, you need to have an MTF account with the broker so that you can avail of the MTF facility.

The broker defines the minimum maintenance level and that needs to be maintained when you are taking a trade under MTF. In case of failure to maintain it, your trade gets squared-off. Prior to squaring-off, the broker intimates you to replenish margin account with additional capital to meet the minimum maintenance level, through a margin call. If replenished, the position will not be squared-off and you can continue to hold it.

Features of Margin Trading

  • As per SEBI regulations, only authorized brokers can offer Margin Trade Funding.
  • Margin Trade Funding facility has to be activated after opening Demat and trading account. Some brokers will require you to submit a Power of Attorney document to activate MTF
  • SEBI and the respective stock exchanges pre-define the shares that can be traded through margin trade funding.

Risks Involved in Margin Trading

  • Profits & Losses - Margin is like a double-edged sword. It can help investors magnify profits & also magnify losses. There’s a great chance that you may end up losing more than what you invested.
  • Minimum Balance – The investor needs to keep a minimum balance in the MTF account at all times when an MTF position is open. In case the balance falls below the minimum level, the broker intimates the investor to meet the minimum balance. If he is unable to, then he is forced to sell some or all the shares under MTF order for the maintenance of the minimum balance.
  • Liquidation – In the event of failure on the investors’ part to keep up with the margin trade terms, the broker may square off the position and liquidate the investor’s assets for recovery of the amount.

Margin Trading in Mutual Funds

Typically, mutual funds cannot be purchased through margin trading due to their trade mechanism. Mutual funds cannot be bought and sold like stocks as the pricing mechanism of equity stocks and mutual funds is different. Investors use mutual fund houses to buy and redeem mutual fund units.

Essential Margin Trade Practices

a) Invest cautiously – If you plan to invest through margin trading, then you need to be aware about its features and your obligations. Margin trading entails both profits and losses. If the market moves in your favour, then you might not face any obligation but if it doesn’t, then you have to get into action and be wary of margin calls. Invest through margin trading only if you have enough cash to cope with the unexpected moves that’s against your margin position and you’re able to meet the margin call.

b) Don’t buy all at once – A common practice of investors is to build the positions gradually over time and not in one go. The first time, if your stocks fall by a certain percentage, you won’t be incurring huge losses at once. With gradually building up your position, you can assess the markets and progress accordingly. This helps to reduce your risk and optimize your returns.

Investments in securities markets are subject to market risks, read all the related documents carefully before investing.As subject to the provisions of SEBI Circular CIR/MRD/DP/54/2017 dated June 13, 2017, and the terms and conditions mentioned in rights and obligations statement issued by the TM. (if applicable)

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