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Margin trading: Exploring the risks and rewards

Margin trading is like getting a loan from your broker to invest in the stock market. It’s like being part of an exclusive circle, but instead of a secret handshake, you’re delving into the world of borrowed funds.

But let’s take a step back for a moment. What exactly is margin trading?

What is margin trading and how does it work?

Margin trading, also known as leverage buying, is a strategy that lets you buy securities or enter derivative contracts by borrowing cash from your brokerage firm. The securities you purchase become your collateral. 

But don’t forget, just like with any loan, you’re required to pay regular interest on the borrowed funds. To initiate a margin trade, investors must have a margin trading account with their broker. 

Margin trading allows investors to buy stocks by paying only a fraction of the actual value, known as the margin. This margin can be paid in cash or shares used as security. 

If the profit earned from the trade is greater than the margin, investors will make a profit. However, if the investment loses value, the loss is magnified due to the leverage provided by margin trading.

It’s important to note that margin trading can amplify both gains and losses. So, while margin trading can be rewarding, it also comes with increased risk. Additionally, brokers charge interest on margin loans, although the rates are typically lower than those of personal loans or credit cards. 

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Eligibility for margin trading

  • Opening the MTF account

Open a margin account with your broker based on margin requirements, terms and conditions. Your broker may require you to meet certain criteria before opening the account.

  • Minimum Balance Maintenance

Once you have your margin account up and running, maintaining a minimum balance in it is essential. 

Margin falling below the minimum balance will be squared off, which means your position will be forcibly closed at the end of each trading session. 

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How is the margin calculated?

  • Margin percentage: Your margin percentage is determined based on the current market value of your portfolio. It serves as a guarantee that you have the financial muscle to back up your trades. 
  • Margin limit: The margin limit is the maximum amount of money your broker allows you to borrow. It’s calculated as a percentage of the total value of securities in your account. 
  • Calculating the Margin: To calculate the margin, subtract the total cost of securities from the total market value of securities. It’s like taking a leap of faith, seeing the difference between what you’ve paid and what they’re worth.

Features of margin trading

  • Amplified market exposure – Leverage is the secret ingredient that fuels margin trading. With a generous 4X leverage, you can unleash the full force of your trading prowess.
  • Market opportunities – Margin trading is not limited to derivative securities alone. You have the freedom to leverage positions in a variety of pre-defined securities approved by SEBI and respective stock exchanges. 
  • Carrying forward positions – The positions created with margin can be carried forward for a maximum of N+T days. N represents the number of days a position can be held, which may vary depending on the broker, while T corresponds to the trading days.

Understanding interest on margin trading

Interest on margin trading plays a significant role in brokerages’ revenue streams and profit models. By charging interest on margin loans, brokers can offer more competitive brokerage rates to customers. 

The interest rates on margin funding are generally fixed but can be negotiated based on your relationship with the broker and the amount of business you provide.

Interest payable = (Rate/365) x principal x time

Advantages of margin trading

  • Seizing short-term opportunities: Margin trading can give you the flexibility to seize short-term opportunities and allows you to make quick moves and potentially capitalise on market fluctuations.
  • Building credit and discipline: Successfully managing margin trades requires discipline, research, and risk management. By honing these skills, you can become a more savvy investor and build a solid credit history.
  • Flexibility and diversification: With increased buying power, you can build a more diversified portfolio and spread your investments across various stocks or sectors. This flexibility may allow you to manage risk more effectively and potentially enhance returns.

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Disadvantages of Margin Trading

  • Interest costs: Margin trading isn’t free. Like any loan, borrowing money from your broker comes with mandatory interest, irrespective of profits or losses.
  • Market volatility can bite: Stocks can be like wild roller coasters, and market volatility can wreak havoc on your borrowed investments. 
  • Margin call: Brokers have a safety net called a margin call. If the value of your investments falls below a certain threshold, your broker may demand additional funds or start selling your assets to recover their loan. 

The bottom line

While margin trading offers the allure of bigger gains and expanded investment opportunities, it’s essential to approach it with caution. Remember, with great power comes great responsibility – and margin trading is no exception!

FAQs

What is an example of margin trading?

You decide to buy Rs. 10,000 worth of XYZ stock. You pay Rs. 5,000 in cash and borrow the remaining Rs. 5,000 through margin trading. 
Profit: If your investment grows by 25% to Rs.12,500, your actual return on investment would be 50% because you only invested Rs. 5,000 of your own money. 
Loss: If your Rs10,000 investment decreases by 25% to Rs. 7,500, you will effectively lose 50% of your initial investment.

Is margin trading a good idea?

Margin trading helps traders take large positions despite low initial investments. However, stock markets are volatile, and losses are equally probable. Losses in margin trading can have a heavy impact as interest payments can be burdensome.

Is margin interest charged daily?

Yes, interest on margins for trading is assessed daily. The charging period may vary, but every day is subject to interest.

Which is better – Intraday or margin?

While margin trading refers to taking loans from the broker, intraday trading is the process of buying and selling shares on the same day. Intraday without margin eliminates the burden of paying interest. However, it is essential to accurately time the trades.

Is margin trading taxable?

Yes, margin trading is subject to taxes. Gains are subject to long term or short term capital gains. Losses can be recorded to set them off against other gains.

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