You are sitting at your computer, watching your favourite stocks rise in value. You want to invest more than you currently can afford, but there is a way to leverage your buying power without waiting until you save enough cash. That is where the margin trading facility (MTF) comes into play. By borrowing funds from your broker, you can purchase more shares than your cash alone would allow. But before you dive in, it’s essential to understand the process, the risks, and the rewards involved in margin trading. This guide will help you overcome this complex yet exciting investment strategy.
History of Margin Trading
Margin trade traces its origins to the early 20th century, becoming popular in the United States in the 1920s. During this period, investors could borrow up to 90% of their investment, a practice that contributed to the stock market crash of 1929. This event prompted the introduction of stricter regulations and reduced leverage limits to safeguard investors and maintain financial stability. Over time, margin trading has adapted to improved regulations, creating a more secure trading landscape.
What is Buying on Margin?
Trading on margin is borrowing funds from a broker to invest in securities. This lets you purchase more stocks than you could with your cash alone, boosting potential returns. However, it also increases risk as losses can be magnified.
When you purchase on market margin, you are required to set up a margin account with your broker. This account enables you to borrow money using your current securities as collateral. The initial deposit you must provide is the initial margin requirement, which is generally 50% of the securities purchase price. For example, if you wish to buy shares worth ₹1,00,000, you must have at least ₹50,000 in your margin account.
After buying the securities, you must keep a minimum balance in your account, referred to as the maintenance margin. If the value of your securities declines below this point, your broker will make a margin call, demanding that you either deposit more money or sell some assets to offset the loss.
How Does Buying Stocks on Margin Work?
Let’s say you choose to purchase shares of Company ABC, trading at ₹500 per share. You have ₹40,000 in your account and wish to buy 160 shares, costing ₹80,000. You invest your ₹40,000 and borrow the remaining ₹40,000 from your broker. If the price of ABC shares increases to ₹700, your investment is now worth ₹1,12,000. After repaying the ₹40,000 borrowed, you are left with ₹72,000, almost doubling your initial investment.
However, if the price drops to ₹300 per share, your investment is now worth only ₹48,000. After repaying the borrowed ₹40,000, you are left with just ₹8,000, resulting in a significant loss of your initial investment.
Benefits of Buying on Margin
The three benefits of buying stocks on margin are:
Amplified Gains
When you trade on margin, you significantly increase your investment capacity by borrowing funds from your broker to invest in securities. This means you can buy more shares than you could with just your available cash. For instance, if you have ₹75,000 in your account and want to purchase shares valued at ₹2,25,000, margin trading lets you borrow the additional ₹1,50,000 from your broker.
Flexibility and Liquidity
Unlike traditional cash accounts, margin accounts allow for greater flexibility and liquidity. You can readily tap into funds for new investments without selling off your existing assets. For example, a margin account lets you act quickly if you find an attractive investment opportunity and your cash is low. This feature is vital in rapidly changing markets. Additionally, margin loans usually have flexible repayment options, enhancing cash flow management.
Diversification
Margin accounts allow you to diversify your portfolio more effectively. By increasing your buying power, you can distribute your investments across various sectors or asset classes, thus minimising the risk of having all your funds in a single investment. For example, starting with ₹1,00,000, margin use can permit you to invest ₹2,00,000, acquiring a larger selection of stocks and potentially reducing risks. This diversification can help stabilise your portfolio in volatile markets.
Risks of Margin Trading
The three most common risks of margin trading are:
Margin Call
A margin call occurs when the asset value in your margin account drops below a required threshold, referred to as the maintenance margin. This typically happens if the market value of the assets you bought on margin decreases. For example, suppose you purchased shares worth ₹1,50,000 by borrowing ₹75,000 from your broker. If the value of these shares falls to ₹1,00,000, your equity will dip below the required maintenance margin, leading to a margin call.
Not responding to a margin call can lead to serious repercussions. If you don’t add more funds or securities to restore your account to the necessary level, your broker is entitled to liquidate some or all of your holdings to cover the deficit.
Volatility
In a volatile market, prices fluctuate wildly, increasing the risk of significant losses. For example, if you use a margin to invest in a stock and its price plummets suddenly, you could find yourself facing a margin call.
To manage these risks, consider distributing your investments among various asset classes, reducing the effects of a single asset’s poor performance. Additionally, using stop-loss orders can limit losses by triggering an automatic sale of a security when it reaches a certain price. Regularly reviewing your margin levels is vital to avoid unexpected margin calls.
Interest Costs
One more risk in margin trading involves interest costs. The interest on the funds you borrow through the margin trading app influences your profitability. For example, borrowing ₹1,00,000 at a 10% annual interest rate means you will owe ₹10,000 in interest after one year. If your investments don’t generate returns that exceed this amount, your overall profit will shrink, and you could end up with a loss.
Suppose you invest ₹2,00,000 in stocks, using ₹1,00,000 of your own money and borrowing the other ₹1,00,000 on margin. If the stock value increases by 20%, your investment grows to ₹2,40,000. After repaying the borrowed ₹1,00,000 and the ₹10,000 interest, you are left with ₹1,30,000, resulting in a net profit of ₹30,000.
How to Start Margin Trading?
Here are the steps involved in starting margin trading in India.
- Step 1: Before you begin, ensure you understand margin trading.
- Step 2: Contact your preferred broker to open a margin account on the MTF app. You may consider a broker like HDFC SKY.Â
- Step 3: Learn about your broker’s margin requirements. This includes the minimum amount you must maintain in your account and the initial margin needed for your purchases.
- Step 4: Carefully select the stocks you want to buy. Focus on companies with strong fundamentals and market trends to increase the potential for profitable returns.
- Step 5: When ready, place your order through your broker’s platform. Specify the number of shares you want to buy and ensure you know the total cost and margin used.
- Step 6: Keep a close eye on your investments. Regularly check stock performance and margin level to avoid margin money calls or liquidation.
- Step 7: If your account value falls below the required margin, be ready to deposit more funds or sell shares. Stay informed to manage risks effectively.
Conclusion
In summary, buying on margin can be an exciting way to increase your investment potential, allowing you to purchase more shares than you could with cash alone. However, it’s vital to fully understand the associated risks, including margin calls and interest costs, which can significantly impact your returns. By being aware of these factors and managing your investments carefully, you can make the most of this strategy while minimising potential downsides. Always approach margin trading with caution and informed decision-making.
To start margin trading, consider opening a demat account first.Â