Margin trading involves buying and selling of securities in one single session.
Margin can escalate your profits on the upside but magnify your losses on the downside.
2 min read
In the stock market, margin trading refers to the process whereby individual investors buy more stocks than they can afford to. It also refers to intraday trading in India and various stock brokers provide this service. 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. It is an easy way of making a fast buck. With the advent of electronic stock exchanges, the once specialized field is now accessible to even small traders.
More definitions of margin trading
Margin trading is also called buying on margin. It is a method of buying shares that involves borrowing a part of the sum needed from the broker executing the transaction. The collateral for the loan is normally securities in the investor’s account. The investor must deposit an initial amount of cash or securities (initial margin or margin requirement) into a margin account with the broker. And must thereafter maintain a minimum amount of cash or securities (margin) in the account as collateral. If the balance of a margin account falls below the minimum maintenance amount, the broker makes a margin call to the investor for the funds needed. Margin balances can be adjusted to reflect market values by adding or subtracting variation margins.
Buying on margin
Buying on margin gives the investor leverage as any capital appreciation or dividend income is on the total amount purchased. Even after the amount borrowed has been repaid to the broker, with interest, the investor could still be better off than if he/she had personally financed the purchase of a smaller amount of shares. That depends on how much the shares gain and how much they yield. There are some risks with margin trading – if the shares fall in value, the investor suffers a capital loss while also facing potential margin calls from the broker.
An example of margin trading
Margin trading is meant for traders who are looking for a simple way to amplify their earnings. And have a reasonable level of risk appetite but do not have enough capital.
In simpler terms, let’s try to understand it with the help of an example.
Let’s say you are 100% bullish for the big company and believe the stock is going to pick up. You want to buy 1000 shares of that company and each share is priced at $200. You would need a capital amount of $200,000 to take up that position. Assuming you have $150,000 and want to get the rest of the capital. With margin trading, your broker can help you with the rest of the funds while charging you a specific interest percentage.
How margin trading works
The process is quite simple. Margin means buying securities, such as stocks, by using funds you borrow from your broker. Buying stock on margin is similar to buying a house with a mortgage. A margin account provides you the resources to buy more quantities of a stock than you can afford at any point in time. For this purpose, the broker would lend the money to buy shares and keep them as collateral.
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 if the stock price goes up
This is the best outcome for you. Let’s say you bought 100 shares for $4000. But you had $2000 and broker loans $2000. If the price goes to $50 per share, your investment will be worth $5,000. Your outstanding margin loan will be $2,000. If you sell, the total proceeds will pay off the loan and leave you with $3,000. Because your initial investment was $2,000, your profit is a solid 50%. Your $2,000 principal amount generated a $1,000 profit. However, if you pay the entire $4,000 upfront without the margin loan your $4,000 investment will generate a profit of $1,000, or 25 percent. Using margin, you will double the return on your money.
The stock price fails to rise
If the stock stays at the same price, you still have to pay interest on that margin loan. If the stock pays dividends, this money can defray some of the cost of the margin loan. In other words, dividends can help you pay off what you borrow from the broker.
Having the stock neither rise nor fall may seem like a neutral situation, but you pay interest on your margin loan with each passing day. For this reason, margin trading can be a good consideration for conservative investors if the stock pays a high dividend. Many times, a high dividend from $5,000 worth of stock can exceed the margin interest you have to pay from the $2,500 (50 percent) you borrow from the broker to buy that stock.
If the stock price goes down
If the stock price goes down, buying on margin can work against you. What if the price in our example goes to $38 per share? The market value of 100 shares will be $3,800, but your equity will shrink to only $1,800 because you have to pay your $2,000 margin loan. You’re not exactly looking at a disaster at this point, but you’d better be careful. The margin loan exceeds 50 percent of your stock investment. If it goes any lower, you may get the dreaded margin call. The broker asks you to restore the ratio between the margin loan and the value of the securities. That’s why margin trading can be dangerous.
Maintaining balance in margin trading
When you buy stock on margin, you must maintain a balanced ratio of margin debt to equity of at least 50 percent. If the debt portion exceeds this limit, you’ll be required to restore that ratio by depositing either more stock or more cash into your brokerage account. The additional stock you deposit can be stock that’s transferred from another account. If you can’t come up with more stock, other securities, or cash, you have to sell stock from the account and use the proceeds to pay off the margin loan. For you, it means realizing a capital loss you lost money on your investment.
The bottom line
As you can see, the margin can escalate your profits on the upside but magnify your losses on the downside. If your stock plummets drastically, you can end up with a margin loan that exceeds the market value of the stock you used the loan to purchase. In the emerging bear market of 2000, many people were hurt by stock losses. A large number of these losses were made worse because people didn’t manage the responsibilities involved with margin trading. To avoid this kind of problems you must have ample reserves of cash or marginable securities in your account.
Some people buy income stocks that have dividend yields that exceed the margin interest rate. That means that the stock ends up paying for its own margin loan. Just remember to stop-loss orders.
If the market turns against you, the result will be very painful if you use margin.
Your ultimate goal is to make money, and paying interest eats into your profits.
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