Margin Trading: A Tale Of Borrowed Money & High Risk

Jul 06, 2017 | 03:41 PM IST

The English expression - to bite off more than one can chew - holds the wisdom of the world. Apply it to any walk of life and you will get the distinction between the right thing to do and the practical thing to do. There is one place where the application of this philosophy will help you take the practical decisions all the time - the stock market. It tempts you, it tests you with its alluring money making prospects. Intraday trading, F&O and margin trading to name a few. If you are familiar with the stock market, then you must have heard these terms or even practised them some time or other. All these things put you in a position where you bite more than you can chew.

The most challenging among them is margin trading. If we have to explain margin trading in simple terms - it means trading on borrowed money. Let's take a closer look at how it works and figure out who should do it and why?

First Thing's First - What Is Margin Trading?

There are two types of margin trading, one that is used for intraday trading and the second where the trader holds the long position (Overnight). In both these scenarios, the percent of margin provided by the broker varies. Margin facility is available for equity, intraday and Futures & Options (F&O).

Margin Trading For Intraday - In intraday trading as the position is bought and sold in the same trading session, the risk of loss (to the brokers) is lesser compared to that of delivery. Hence a sizable margin is provided to the clients who wish to buy huge quantities of shares. In intraday, sometimes the margin of 15-20% is provided, where the trader just has to pay the 15-20% of the total cost of the transaction. For example, if a trader has to buy 1000 shares of XYZ Company at Rs. 300, the actual cost of this trade would be (1000*300) 300,000. However, if you get a margin of 15% you can buy the shares at just Rs. 45,000.

Margin Trading For Long Position (Leverage) - When a trader wants to hold a long position on any trade (Overnight) for such trades the margin provided is based on the stock holdings of the trader. So if a trader is holding good stocks (Blue-chip stocks) he will get good leverage. In a way, the stock holding in the DP account of the trader is kept as a collateral and only 50% of the asset value is given out as a margin. In such trades, the trader is obliged to pay the amount borrowed from the broker and the interest for the same has to be paid too.

Under the new regulations of SEBI, the trader has to pay back the outstanding amount to the broker in 5 business days or the broker has to square off the stocks.

Margin Trading - Good, Bad & Ugly?

Let's address the key questions like what are the upsides and downsides of margin trading. And most importantly, who should do it and who should stay miles away from it.

So, just like every other thing, margin trading has good as well as not so good things to offer.

A Big Boost To The Buying Power - One of the biggest advantages of margin trading is that it immensely increases your buying power. If a trader knows what he is doing and is confident of his research and analysis and if the only thing that is holding him back from making a trade is a lack of funds, then the margin facility is a tailor-made option for such traders. It enables traders to buy much more stocks than what they would have with the cash available.

Ample Opportunities Of Growth - In the stock market, there are various opportunities available to multiply your capital. Margin facility is a vital resource for traders to capitalise on these opportunities. In a way, trading on margin is a double-edged sword, which if used with caution and intelligence, can give big benefits to the traders.

As we called margin trading a double-edged sword, let's shed some light on the other 'edge' - the downside of margin trading.

Extreme Risk - The objective of margin trade is to chance upon the slight movements of the stock and to gain from such movements it's important that you buy the stocks in big quantity. Thus a trader goes for a margin trade. Now, the trader has entered the stock thinking that it will move upward, but if the stock moves downward the trader exposes himself to massive risk.

Margin trading is an extremely risky, as to get decent gain you have to buy stocks in a huge quantity. For example, if you buy 1000 shares of XYZ company at Rs. 500, the cost of that trade would be Rs. 5,00,000. If you get 20% margin, you only have to pay Rs. 100,000. In the worst case scenario, if the stock falls 20% in a day, your entire capital will get wiped out in a single trading session.

A Stressful Activity - There are many investors/traders out there who can't see their account going in the red. Their pulse start racing and hands start getting clammy. Now if you are doing margin trading, multiply that effect with hundred. Yes, the losses in margin trading, just like profits, are in a very high quantity. As mentioned above, the traders chance upon the slight upward movement, in the same way, it can move downward and bring you serious losses. The big losses are subsequently going to increase your stress level which will adversely affect your health.

The 'Margin Call' Means Game Over - While trading on margin, traders hope and pray that they will not get a margin call. When the value of the stock (bought on margin) falls below the purchase price, traders get a call from the broker to deposit additional margin. In case traders fail to deposit money or the value of the stock falls further down, the broker squares off the stocks to minimise the losses and to salvage his funds.

The Key Question - Should We Or Shouldn't We?

Let's go back to the expression we started this discussion with - to bite off more than one can chew. Every investor should ask himself these three questions before using margin - 1. Am I biting off more than I can chew? 2. Is the risk I’m about to take justified by rational means? 3. And most importantly, is the risk backed by robust research and analysis? If the answer to all three questions is a YES then take the plunge. But if the answer is NO then it will be a wise decision to just stick to the basics and enjoy the benefits of the good old long-term investment.

 

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Niveza Editorial Desk : We are a team of stock market nerds trying to stay ahead of the herd. We spend our grey cells everyday to pave a smooth road for our clients in the shaky world of stock market. While...
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