14.5 Margin trading
While discussing about short term trading, it is important to know about the concept of margin trading. Let us discuss the concept called margin trading with an example; Suppose Mahesh has Rs 1000 in his bank account. Mahesh can use this amount to buy 10 shares of xyz company @ Rs 100/share. In the normal course, Mahesh will pay for the shares on the settlement day to the exchange and receive 10 shares from the exchange which will get credited to his demat account. Alternatively he could use margin exposure. For margin exposure let us assume that the applicable exposure is 4 times. Now, Mahesh could buy up to 40 shares of xyz company at Rs 100 value for Rs 4,000, the margin exposure of 4 times i.e. on Rs 1,000 he can buy share worth Rs 4,000. As he does not have the money to take delivery of 40 shares of xyz company he has to cover (square) his purchase transaction by placing a sell order by the end of the settlement cycle. Now suppose the price of xyz company rises to Rs.110 before the end of the settlement cycle. In this case, Mahesh’s profit is Rs 400 which is much higher than Rs 100 on the 10 shares which he would have bought with the intent to take delivery. When you buy a stock on margin, you pay for part of the purchase and borrow the rest from your brokerage firm. “Margin” is borrowing money from your broker to buy a stock and using your investment as collateral. Investors generally use margin to increase their purchasing power so that they can own more stock without fully paying for it.
But margin trading exposes investors to the potential for higher losses. In the above example, assume that the price of shares came down from Rs 100 to Rs 90, then on the 40 shares which he has bought he would have lost Rs 400 while in the normal situation he would have bought only 10 shares and lost Rs. 100 only. Plus the interest charged by the broking house on the margin amount would have been the additional loss. In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Before opening a margin account, you should fully understand that:
- You can lose money even more than you have invested.
- You may have to deposit additional cash or securities in your account on short notice to cover market losses.
- Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.
To open a margin account, your broker is required to obtain your signature. The agreement may be part of your account opening agreement or may be a separate agreement. Be sure to carefully review the agreement before you sign it. With most of the loans, the margin agreement explains the terms and conditions of the margin account. The agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Please note that all stocks are not allowed under margin trading in India. Only those stocks, which meet the criteria on liquidity and volume, are considered for margin trading. Besides, margin exposure varies with various categories of shares.