When an investor borrows money from his broker to buy stocks, the process is called Margin Trading. Margin is a way of increasing your purchasing power for investments. Buying on margin means that you take a loan from your broker to increase the amount of funds you have at your disposal to invest. The loan comes with its own costs in the form of interest and there are limitations on how you use the loaned funds. If you wish to go for trade in margin then you need to have a margin account. Once your margin account gets activated, then you can borrow up to 50% of the purchase price of the stock. Below are certain terms that would make the concept more clear.
- Initial margin: The proportion of total purchase price an investor is supposed to deposit for opening a margin account is referred as its initial margin and is generally 50% of the total value.
- Maintenance margin (Minimum margin): In order to keep the margin account open for doing margin trading, it is necessary to maintain minimum cash or marginable securities which is called the maintenance margin. This is just to prevent an investor from incurring a level of debt that he would not be able to repay.
- Margin call: If your account falls below the maintenance margin, your broker will make a margin call to ask you to deposit more cash or securities into your account. If case you fail to meet the margin call, your broker will sell your securities so to make up for the stipulated maintenance requirement
In order to trade with a margin account, you are first required to place a request with your broker to open a margin account. This requires you to pay a certain amount of money upfront to the broker in cash, which is called the minimum margin. This would help the broker recover some money by squaring off, should the trader lose the bet and fail to recuperate the money.
Once the account is open, you are required to pay an initial margin (IM), which is a certain percentage of the total traded value pre-determined by the broker. Before you start trading, you need to remember three important steps. First, you need to maintain the minimum margin (MM) through the session, because on a very volatile day, the stock price can fall more than one had anticipated.
Margin trading involves buying and selling of securities in one single session. Over time, various brokerages have relaxed the approach on time duration. The process requires an investor to speculate or guess the stock movement in a particular session. Margin trading is an easy way of making a fast buck.
How Does Leveraging Works
Let’s say you buy a stock for Rs. 60 and the price of the stock rises to Rs. 75. If you bought the stock in ‘Cash” Segment and paid for it in full, you’ll earn a 25 percent return on your investment. But if you bought the stock on margin (say 33.33%) paying only Rs. 20 in cash – you’ll earn a 75 percent return on the money you invested.
The downside of using margin is that if the stock price moves unfavorably, losses can mount quickly. For example, let’s say the stock you bought for Rs. 60 falls to Rs. 39. If you fully paid for the stock, you’ll lose 35 percent of your money. But if you bought on margin, you’ll lose more than 100 percent.
Example of Margin Trading
If a Tata Steel stock priced at Rs 400 falls 4.25 per cent and the initial margin and minimum margin are 8 per cent and 4 per cent of the total value of the shares bought, respectively, then the trade-off 8%-4.25%=3.75% will be less than the minimum margin. In this case, you will either have to give more money to the broker to maintain the margin or the trade will get squared off automatically by the broker.
Secondly, you need to square off your position at the end of every trading session. If you have bought shares, you have to sell them. And if you have sold shares, you will have to buy them at the end of the session.
Thirdly, convert it into a delivery order after trade, in which case you will have to keep the cash ready to buy all the shares you had bought during the session and to pay the broker’s fees and additional charges.
If even one of these steps is missed, the broker will automatically square off the position in the market.