Navigating margin funding: Advantages and risks of the trading strategy

Investors are on constant lookout for investing opportunities that would help them reap profits. However, most investors often work on a set amount that they can afford to invest and so their gains are also limited. 

To counter this, there is an option for margin trading that allows investors to trade more money than they can afford to by seeking funding from the brokers. 

In this article, we will introduce you to what is margin funding, its eligibility criteria, advantages, and risks to help you make an informed decision. 

What is margin funding in trading?

Margin trading refers to a trading process where investors aim to increase their potential returns by investing more money than they can afford to. Investors can make stock purchases at a marginal price of the actual value. The gap in the funding is covered by the brokers who provide investors with cash for the remaining amount. 

Margin trading aims to help investors get a better chance at earning higher profits by leveraging a higher amount of investment. However, investors must keep in mind that margin trading is risky and there is profit only when the total profit earned exceeds the margin. 

While earlier, SEBI allowed margin trading only via cash, it has now opened the opportunity of providing shares as security. Also, keep in mind that margin trading can only be offered by an authorised broker. 

Let us look at a marginal cost of funds example to better understand the concept of margin trading. For example, X purchases a stock worth INR 80 initially but while squaring off the price of the stock increases to INR 90. 

Had X brought the stock in full cash payment, there would be a profit of 12.5%. Now imagine that this trade was executed with margin funding and only INR 30 was used to purchase the stock, the return on investment now would be 75%.

This is how marginal cost of funds calculation is done and the profits increase tremendously with this strategy. 

Eligibility for margin trading 

Next, let us consider the eligibility of margin funding to better understand the process. It is imperative to have an MTF-margin account with the broker. An amount is charged at the opening of the MTF account and it is mandatory to maintain a minimum balance in the account or the trade will be squared off. 

Keep in mind that the marginal cost of funds-based lending rates differs between different brokers. 

Advantages of margin trading 

Margin trading funding comes with a host of advantages for investors. Some of the key advantages include: 

Short term profit

The margin trading option is best suited for individuals who wish to capitalise on the short-term price fluctuation of the stock market. Even though they might not have funds they can source margin funds and make short-term gains. 

Maximised returns

Another advantage of margin trading is that it allows investors to get the maximum rate of return on their investment capital. 

Security as collateral

While initially not allowed, investors can now utilise their securities in their investment portfolio or demat account as security for margin trading. 

Security measure

Investors trading under margin funding are secure because it is under constant supervision of the Securities and Exchange Board of India (SEBI). 

Leverage market position

The margin trading opportunity allows investors to profitably utilise their securities positions that are not from the derivatives sector. 

Risks of margin trading 

With the core advantages, it is also crucial for investors to understand the risks of margin trading to allow them to make an informed decision. The potential risks of margin trading include: 

High risks

The main risk of margin trading is that in case of losses, the investors can end up losing more money than they had invested. 

Minimum balance requirement

It is crucial to maintain a minimum balance mandated by the broker in the margin funding account. In case the funds go below the required minimum, the investors must either deposit more cash or sell some stocks to maintain the minimum balance. 

Liquidation risk

In case the investor fails to honour the marginal agreement, the brokers are permitted to liquidate their assets in MTF to cover up their losses. 

With these risks associated with margin trading, investors must take calculated steps when investing through margin trading. 

Best practices of margin trading

To minimise the risks of margin trading, here are some best practices that investors can follow:

Settle margin

The investors get money from the brokers as a loan and must pay interest on it. It is recommended to pay back the margin as soon as possible to eliminate the accumulation of interest. 

Minimal borrowing

Investors must not borrow the maximum permissible amount. To begin with, they must borrow only the necessary sum and then go ahead with margin trading only when they are confident of the profits. 

Sufficient cash

Lastly, since margin funding takes place with high risks, the investors should have sufficient funds to cover the margin requirements in case of unfavourable market conditions. 

Conclusion 

Trading at the marginal cost of funds is an ideal option for investors looking to amplify their gains. It is the practice of trading on borrowed money while depositing cash as collateral. 

There are both sides, the investor can gain additional profits if the market conditions are favourable compared with what they could have earned with their money and they can similarly also lose more. As a result, investors must consider both the risks and the advantages and also understand the marginal cost of funds based lending rate. 

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