All about Margin Trading - Risks and Advantages

If you're fairly attuned to investment strategies and types of trading, there is a chance that you’ve heard of margin trading, and that it piqued your interest. It sounds like a great technique, that lets you invest more and bring in greater ROI. But you might not want to rush in shouting “Stonks!” just yet.

 

Margin trading is a high stakes game. Did you know that unregulated margin trade was one of the main causes behind the stock market crash of 1929? Don’t get disheartened, it is still a valuable strategy. You simply need to be well informed of its workings, risks, and benefits, before you decide whether or not it’s worth it.

 

(Recommended blog - 6 Basic Trading Principles )

 

 

What is Margin Trading?

 

Generally, you use the money available to you in your regular cash account to make investments. This is also called spot trading.

 

In margin trading, also called buying on margin, you borrow money from the brokerage to make an investment. The returns can be greater, but the risks are greater too. Margin is the money you borrow.

 

You're taking out a loan to increase your buying power. This is called using leverage to increase your investment. The loan is taken against your securities- your margin account balance, existing stocks, and the investment you're using the margin for. Margin loans are charged an interest rate that varies according to the brokerage. There is generally no set time period of repayment.

 

You can set up a margin account with your brokerage and sign a margin agreement, to begin margin trading.

 

( Recommended blog - Top 10 Benefits of the Stock Market )

 

 

How Does Margin Trading Work?

 

Say, for instance, you make an investment in 100 shares at ₹100 per share. But you only have ₹5000 in cash available, where you would need ₹10000. Here you could borrow an extra ₹5000 on margin, and buy the 100 shares.

 

Now say the stock value rises to ₹12000 when you sell it. You can pay back the margin you borrowed, neglecting interest- ₹5000- and would still have made ₹2000 in profit. This gives you a 40% return on investment.

 

Now say you hadn’t borrowed on margin and invested the ₹10000 yourself. When the stock value rises to ₹12000, you would only have made a 20% return on investment.

 

But greater profits also mean greater risks. Say the stock value fell to ₹8000. If you had borrowed on margin, you have to pay back ₹5000, which leaves you with the value of the stock at ₹3000. This means a 40% loss for you. If you had not borrowed, you would only be facing a 20% loss.

 

The worst-case scenario in margin trading is that you could lose even more than your initial investment. If your ₹10000 stock fell to a value below ₹5000, say ₹4000, even after selling off the shares, you would be ₹1000 in debt.

---

How Margin Trading Works- Profit and Loss Scenarios

---

 

What to Consider in Margin Trading

 

Margin trading can be potentially done by any investor looking for a quick way to increase their buying power. But there are several aspects to consider before deciding if it is the right track for you.

 

• Margin Debit Balance: You need to put up an initial balance in your margin account. The balance you have in your margin account may also affect the interest rates you pay on your loan.

 

• Initial Investment: You usually cannot borrow on margin a value more than 50% of the total value of the investment, sometimes even lower.

 

• Maintenance margin: This is the minimum equity requirement that you must maintain on a stock. For instance, if you make an investment putting in ₹5000 yourself and ₹5000 on margin, and the stock falls from an initial value of ₹10000 to ₹7000, you own ₹2000- less than 30% of the investment. If your broker’s equity requirement is 30%, you fall below the maintenance margin. 25% is the usual margin set by brokerages, but it varies, and may even go up to 40%.

 

• Eligibility: Not all investments are eligible for margin trading. Mutual funds are not, for example.

 

( Recommended blog - Equity Financing: Sources, Advantages & Disadvantages )

 

 

Advantages of Margin Trading

 

Margin trading offers you several advantages that makes it an option worth considering.

 

• Amplifies your profits: When looking at the numbers, it may not seem like there is a difference between the profits on spot trading and margin trading. If your investment increases in value from ₹10000 to ₹12000, you get a profit of ₹2000, regardless of if you were trading on margin or not. And you could argue that you get fewer profits with margin trading, considering you have to pay a small interest amount on your margin loan. But when you look at the percentage ROI, there is a significant difference. 

 

• Increases your buying power: Buying on margin enables you to invest in higher-value stocks that you possibly couldn’t have afforded otherwise.

 

• Helps you diversify: With margin trading, you get to invest in more stocks, which reduces risk and increases the likelihood for an investor to place a winning bet.

 

 

Risks Involved in Margin Trading

 

As with most things, the toss side of the high return technique is that it presents high risks too.

 

• Amplifies your losses: If the stock value falls, margin trading can give you great losses. In a situation similar to the scenario illustrated above, it can even cause you to lose more than your initial investment and put you into debt.

 

• Margin call: A margin call is when the broker demands that your account be brought back to minimum requirements. You can pay off your loan, or they can sell your securities. You can lose a lot of your assets in case of a margin call. Margin calls are usually made when your equity falls below the required level. It is also within the rights of the brokerage to make a margin call without notifying you. Some may give you time to salvage the situation, but some may not.

 

( Recommended blog - Introduction to Stock Market Analysis )

 

 

Is Margin Trading Worth it?

 

Margin trading can be potentially done by any investor looking for a quick way to increase their buying power. It is something with the potential to give you greater ROI and help you buy bigger and more diverse stocks. But if done wrong, it can get you into a whole lot of trouble.

 

Consider the factors mentioned above- margin debit, maintenance margin and margin call, interest rates, and the like- for your brokerage, and deliberate carefully before going into margin trading.

 

Margin trading is not for those who would like to invest and then forget- it needs careful attentiveness. When starting out, keep your buys on margin small and short. Focus on diverse, small, short-term trades to minimize risk. Consider how much risk you can afford to take, and take smaller margins and set maintenance limits for yourself accordingly.