Skip to main content

Stock Market: Margin trading - A high-risk trading

Margin trading increases your buying power, but it enlarges your risk as well. When to give in to the temptation of this high-risk trading strategy, and when to avoid
Double gain; Double pain. This is how the concept of margin trading can best be described. As the name suggests, margin trading enables you to trade with borrowed funds/ securities or, in other words, by paying only a part of the total investment amount. It is, in fact, a leveraging mechanism which enables you to take exposure in the stock market over and above what is possible with your own resources.

However, while margin trading increases your buying power, it enlarges your risk as well. In a way, amplifying your gains and losses to the same degree. That is why it is still not a recommended way of trading, although the lure of big money has always drawn investors into the lap of margin trading. So much so that an increasing number of small investors are now giving in to the temptation of this high-risk trading strategy which had traditionally attracted only short-term punters and deep pocketed investors.

To understand the mechanism of margin trading more clearly, let’s take the case of a person who buys 600 shares of XYZ Co at Rs 400, using the margin finance facility. Assuming his broker offers him 50% leverage on the transaction, person effectively pays only half the total transaction amount (Rs 120,000 out of Rs 240,000) at the time of purchase. The balance is borrowed from the broker/ bank. Now, if the share price rises to, say, Rs 450 after a few days, Mehra would be richer by Rs 30,000 (minus the interest that he would have to pay to the broker/ bank for the borrowed money) and the bank/ broker would gain to the extent of the interest amount on the funds borrowed. However, if the share price drops to Rs 360, person would be incurring a loss of Rs 40 per share, exposing his financier to more risk if the share price were to plummet further.

It is typically during such times that the broker is forced to make margin calls to clients, asking them to either deposit more money into their account or sell some of the securities in their account to meet the margin shortfall.

Now if that person fails to make good the margin shortfall, his stock broker would sell his shares for the stipulated amount in consideration. Thus, apart from losing his investment, person would also stand to lose the opportunity to make any profit in the future, were the share prices to recover.

However, if you look at the same transaction without the margin trading facility, you will realise that though it trims the profits, it effectively reduces the risk when the share price slides. If person had not used the margin trading facility while buying shares, he would not have liquidated his holdings when the market corrected. It is another matter that unlike the previous transaction, he would have been able to buy only 300 shares.

Thus, given that margin trading can lead to inflated profits and losses, experts advise that it should be opted only by traders with a high-risk appetite. Risk-averse or general investors should better keep off from it.

Anyway, you are not allowed to dabble in margin trading on your own as market regulator Sebi, from time to time, has been prescribing eligibility conditions and procedural details for allowing this facility. Thus, for availing of this facility, you need to register, as prescribed by Sebi.
You need to fill in the prescribed documents such as Margin Trading Letter, Margin Trading Agreement and New Finance Letter, apart from account opening and DP Form.

Also, only corporate brokers with a net worth of at least Rs 3 crore are currently eligible for providing the margin trading facility to their clients. Before providing this facility, however, the member and the client have been mandated to sign an agreement for this purpose in the format specified by SEBI. The agreement provides the terms of margin trading, the extent of margin and other details.

The initial margin has been prescribed as 50% and the maintenance margin as 40%. Also, the ‘total exposure’ of the broker towards the margin trading facility should not exceed the borrowed funds and 50% of his ‘net worth’. While providing the margin trading facility, the broker has to ensure that the exposure to a single client does not exceed 10% of the ‘total exposure’ of the broker.

For providing this facility, a broker may use his own funds or borrow from scheduled commercial banks or NBFCs regulated by the RBI. However, the broker has not been allowed to borrow funds from any other source

It has also been specified that the client shall not avail the facility from more than one broker at a time. Another significant point to note is that the facility of margin trading is available for Group 1 securities and those which are offered in IPOs. The list of scrips which are covered by this facility for NSE and BSE are limited (about 600). Any scrip which is not included in the said list shall not be funded.

Thus, given the complexities of margin trading, you should invest only if you have an above average understanding of the market. Otherwise your losses would be more than your gains.

Systematic Trading Systems used with a lot of discipline is also one smart way to make money using margin trading facilities. The important aspect of this system is that human emotion is not involved in this and all buying and selling triggers are generated by a software which is based on a scientific analysis of historical market trends. Whatever be the case, experts advise investors to put only that much money which they can afford to lose. This is just to ensure that one’s life-long earnings are not wiped out through this process!

WATCH OUT

· Margin trading amplifies your gains and losses to the same degree
· It should be opted only by traders with a highrisk appetite and who have surplus cash to back them up during a stock market meltdown
· Invest only if you are a savvy investor and have the stomach for calculated risks
· Do it for short-term bets only
· Put only that much money which you can afford to lose
· Trading software can also help you take prudent decisions based on technicals, not emotions

Popular posts from this blog

All about "Derivatives"

What are derivatives? Derivatives are financial instruments, which as the name suggests, derive their value from another asset — called the underlying. What are the typical underlying assets? Any asset, whose price is dynamic, probably has a derivative contract today. The most popular ones being stocks, indices, precious metals, commodities, agro products, currencies, etc. Why were they invented? In an increasingly dynamic world, prices of virtually all assets keep changing, thereby exposing participants to price risks. Hence, derivatives were invented to negate these price fluctuations. For example, a wheat farmer expects to sell his crop at the current price of Rs 10/kg and make profits of Rs 2/kg. But, by the time his crop is ready, the price of wheat may have gone down to Rs 5/kg, making him sell his crop at a loss of Rs 3/kg. In order to avoid this, he may enter into a forward contract, agreeing to sell wheat at Rs 10/ kg, right at the outset. So, even if the price of wheat falls ...

Mutual Fund MIPs can give better returns than Post Office MIS

Post Office MIS vs  Mutual Fund MIPs   Post office Monthly Income Scheme has for long been a favourite with investors who want regular monthly income from their investments. They offer risk free 8.5% returns and are especially preferred by conservative investors, like retirees who need regular monthly income from their investments. However, top performing mutual fund monthly income plans (MIPs) have beaten Post Office Monthly Income Scheme (MIS), in terms of annualized returns over the last 5 years, by investing a small part of the corpus in equities which can give higher returns than fixed income investments. The value proposition of the mutual fund aggressive MIPs is that, the interest from debt investment is supplemented by an additional boost to equity returns. Please see the chart below for five year annualized returns from Post office MIS and top performing mutual fund MIPs, monthly d...

NRI Corner: The process of remittances abroad

The process of remittances abroad, and back, is cumbersome. Here’s how you can wade through without hassles Approach The Right Place Outward remittances or the process of sending money abroad is governed by many regulations. In India, outward remittances are made mainly through banks. At the outset, you need to remember that you just cannot trust any individual or a financial firm with the responsibility of sending your money. Experts recommend that you should always try to choose a bank with an international footprint, which will make your job easier. Choose Mode Of Transfer The next step is to choose the mode of transfer. One option is to get a Foreign Currency Demand Draft ( FCDD ). This draft will be denominated in foreign currency and should be drawn in favour of the recipient/ beneficiary. The beneficiary does not necessarily need to have an account with the same bank. The other option is to send money via wire transfer. Do not be puzzled if the bank official uses the word SWIFT ...

SBI bonds FAQ

  Maximum retail subscription and over – subscription There is a lot of excitement around these bonds, so I won't be surprised if they get over-subscribed on the first day itself. So, I thought Sameer asked a very good question about over-subscription. Here is that discussion. Here are some other questions that you may find useful. Can I trade the SBI bonds on NSE after it lists? Yes, these can be traded after listing. Where can I get the application forms, and can I buy the bonds online? You can get the application from notified branches, and then fill it up there and submit it. To the best of my knowledge, there is no way to invest in them online, but if anyone knows otherwise then please leave a message, and let us know. Can NRIs apply for these bonds? NRIs can't apply for these bonds as they fall under one of the ineligible categories. Can you take a loan by keeping the SBI bonds as security? The terms of the issue in the prospectus state that the bank shall no...

Principal Emerging Bluechip

In its near ten year history, this fund has managed to consistently beat its benchmark by huge margins The primary aim of Principal Emerging Bluechip fund is to achieve long term capital appreciation by investing in equity and related instruments of mid and small-cap companies. In its near ten year history, this fund has managed to consistently beat its benchmark by huge margins. This fund defined the mid-cap universe as stocks with the market capitalisation that falls within the range of the Nifty Midcap Index. But, it can pick stocks from outside this index and also into IPOs where the market capitalisation falls into this range. Principal Emerging Bluechip fund's portfolio is well diversified in up to 70 stocks, which has aided in its performance over different market cycles. On analysing its portfolio, the investments are in quality companies that meet its investment criteria with a growth-style approach. Not a very big-sized fund, it has all the necessary traits to invest with...
Related Posts Plugin for WordPress, Blogger...
Invest in Tax Saving Mutual Funds Download Any Applications
Transact Mutual Funds Online Invest Online
Buy Gold Mutual Funds Invest Now