What is Margin Trading? Advantages & Risks

It is a common myth that you must have bucketloads of money to trade in stock markets. The answer to this myth is margin trading. It is a boon for traders who lack the necessary capital to take huge positions and thereby increase their portfolios. So, what is margin trading and how does it work? Delve into this blog to learn about margin trading, its risks and advantages.. 

How does Margin Trading Work?

Margin trading is like having a loan account with your broker. Margin trading allows traders to borrow funds from their brokers to purchase securities using their existing investments as collateral. This practice enables traders to buy more shares than they could with their available capital alone thereby potentially giving them access to more funds and trading opportunities.. 

To use a Margin Trading Facility (MTF), traders need to open an MTF account with their broker. Traders must pledge their securities to access the margin trading facility. The broker then provides additional funds to enhance the trader's buying power and charges interest on the borrowed amount. The Securities and Exchange Board of India (SEBI) periodically specifies the rules, eligible securities, and minimum margin requirements for margin trading.

Here is a margin trading example for a better understanding of the concept.

Consider investor Y has Rs. 30,000 and wants to buy shares worth Rs.75,000. This can be done using the margin trading facility. Assume the broker’s margin is set at  20%, which means Y would have to pay Rs. 15,000 (20% of Rs.75,000). The broker would lend the balance Rs. 60,000 and charge interest on this loan. If the value of the shares rises to Rs. 82,500, Y’s return on their Rs. 15,000 investment would be substantial. However, if the market declines, Y could face losses. 

Components of Margin Trading

Some of the key components of margin trading are explained below.

Margin Agreement

A margin agreement is a legal contract between the investor and the broker outlining the terms and conditions of the margin account. This agreement specifies the interest rates, margin requirements, and the broker's rights to take action in the event of a margin call or default.

Initial Margin

The initial margin is the percentage of the purchase price of the securities that the trader must pay with their own funds when entering a margin trade. The initial margin requirements, as per SEBI are designed to ensure the financial stability of the securities market. For example, stock brokers can offer up to 5x margin for intraday trading. This upfront payment varies based on the broker’s policies and the type of securities being traded.

Maintenance Margin

The maintenance margin is the minimum amount of equity that a trader must maintain in their margin account at all times throughout the trading session after purchasing securities. This ensures that there is sufficient collateral to cover the borrowed funds even if the market value of the securities declines.

Margin Call

A margin call is a demand by the broker to deposit additional funds in the margin account. It is triggered when the value of the collateral falls below the broker's required minimum margin level. If the trader fails to meet the margin call, the broker can square off the positions to meet the shortfall.

Collateral

Collateral is the existing securities that the trader uses to secure the borrowed funds in a margin account. The value of the collateral affects the amount the trader can borrow and serves as a safety net for the broker in case the trade goes against the investor. 

What are the Features of Margin Trading in India?

Margin trading has become widely popular on the backdrop of increased retail participation in stock trading in India. Some of the top features of margin trading include

• Increased buying power - Margin trading helps traders shape their trading portfolio even with the restraints of limited capital. 

• Regulated by SEBI - Margin trading is governed by SEBI, which sets guidelines and periodically updates the list of eligible securities for margin trading.

• Leverage - MTF allows traders to amplify their purchasing power by borrowing funds from brokers, enabling larger positions than their available capital would permit.

• Eligible Securities - Eligible securities under MTF as per SEBI include Group I equity shares and units of ETFs categorised as Group I securities. The list of eligible securities is updated by SEBI via circulars occasionally. 

• Interest Charges - Traders are charged interest on borrowed funds, and the rates vary among brokers, impacting overall profitability.

• Squaring Off - If margin requirements are not met, Brokers can liquidate the trader’s positions to recover the loaned amount.

Advantages and Disadvantages of Margin Trading

Now that we have seen the major details of margin trading let us consider a few advantages and disadvantages. 

Conclusion

Margin trading is a common facility used by traders to access stock trading efficiently. Traders can amplify their gains but also face the downside of excessive losses due to market volatility. Therefore, traders need to use the margin trading facility cautiously and implement effective risk management strategies to counter the potential downsides of margin trading.