Why is margin trading considered to be a double-edged sword?
What exactly is margin trading?
Individuals engage in margin trading when they buy more equities in the stock market than they can afford. Different stockbrokers offer margin trading, commonly known as intraday trading in India. You acknowledge and sell securities all at once when you trade on margin. Over time, various brokerages have loosened their time length policies. An investor must speculate or guess the stock movement in a given session as part of the method. Margin trading is a simple approach to generating quick money. Thanks to electronic stock exchanges, even small dealers can now participate in the traditionally specialised industry.
The procedure is simple to follow. This entails paying a set amount of money to the broker, known as the minimum margin. Squaring off will assist the broker in regaining some money if the trader loses the wager and cannot collect the money.
You must pay an initial margin (IM) when you open an account, which is a percentage of the entire traded value that the broker predetermines. Before you begin trading, you must remember three critical processes. You must first maintain the minimum margin (MM) throughout the session on a very rough day, as the stock price may fall further than expected.
For example, if a Tata Steel stock valued at Rs 400 falls 4.25 per cent and the IM and MM are 8% and 4% of the total value of the shares bought, respectively, the trade-off will be smaller than the MM (8 per cent -4.25 per cent =3.75 per cent). To keep the margin, you’ll either have to pay the broker, the broker will automatically square off more money, or the trade.
Second, you must square off your position at the end of each trading session. You must sell shares if you have purchased them. And if you traded shares during the session, you’ll have to repurchase them at the end.
Third, after trading, convert it to a delivery order, in which case you’ll need to keep cash on hand to buy all of the shares you purchased during the session and pay the broker’s fees and other expenses.
If any of these stages are skipped, the broker will automatically square off the market position.
How Margin Trading Works
The broker can deposit funds into the Margin Trading Facility (MTF) account, which the investor can utilise to purchase shares. The amount disbursed is a loan secured by cash (minimum margin) or acquired securities as collateral.
Let’s say an investor wishes to acquire Rs. 100,000 worth of stock but does not have the total amount. He can, however, pay a fraction of the total price for the shares. The margin is this amount.
Assume the profit margin was 20% in this scenario. The investor must then pay the broker Rs.20,000 (20 per cent of Rs.1,00000) before purchasing, with the broker lending the balance Rs 80,000. The investor will pay the broker interest on the margin amount.
The Advantages of Using Margin
According to Jennings, qualified investors can utilise margin to diversify beyond standard stocks, employ margin in buy-and-hold strategies, and expand into options-based processes. “You can access more funds across the board” with margin. “In terms of diversification, you may purchase several different stocks or ETFs instead of purchasing 100 shares of a single stock. You can also sell stocks short and profit if the stock price drops.” Of course, shorting stocks carries an endless risk of loss because there is no limit to how high a stock’s price might rise.
Margin can be exploited, and it has been blamed for some of the market turbulence in the past (the October 1929 crash, for example). As a result, “there’s a little bit of shame about margin,” according to Jennings.
- Ideal for Profit Generation in the Short Term: Margin trading is advantageous for investors who want to profit from short-term price swings in the stock market but don’t have enough funds to invest.
- Market Position of Leverage: Margin trading allows investors to acquire vast shares for a lower price, increasing their leverage. Leverage positions them in a favourable position to profit from even minor market fluctuations. However, it must be cautioned, as negative price movement magnifies losses proportionally.
Only when the rate of return on the investment is higher than the interest rate on loan is a margin trade advantageous. It amplifies both gains and losses.
You put Rs.50,000 into a stock with the expectation of more significant returns, but the stock value has dropped to Rs. 45,000. You are responsible for both the losses and the interest on the broker’s loan.
A margin call occurs when a margin account balance falls below the minimum maintenance margin. A margin account usually runs out of money after a bad deal. The broker can demand that traders deposit funds maintain the minimum maintenance margin. If the trader cannot do so, the order can be squared off at market price by the broker.
Margin Trading Features
The Perils of Margin Trading
- Exaggerated Losses
Margin trading might help you increase your profits, but it can also increase your losses. It can also result in the complete loss of all invested funds.
- Balance Required
The investor must maintain a minimum balance in the margin trade facility account. As a result, a portion of their money is always locked up. Suppose the account balance falls below the minimum necessary balance. In that case, the broker will force the investor to add cash or sell a portion of their holdings to maintain the minimum balance.
Investors must follow the requirements for using the margin trading facility. A margin call is triggered when an investor takes a position using margin trading, and the trade goes sour, causing the balance to fall below the minimum margin. The broker can close the business and liquidate the assets if the investor fails to meet the margin call.
Why is Margin Trading so dangerous?
Let’s go over the last example once again. We had considered if the trader was correct in his assessment until now. What if he was incorrect, and the stock fell by Rs 30 a share? A classic case of oops-a-daisy.
Your total loss with margin will be Rs 3000, and without margin would be Rs 300. Only traders are harmed or benefited by margins; brokers receive their brokerages either way!
Do you get Philip Carret’s cautious tone now? You may compare margin trading to a magnifying glass that magnifies your profit or loss.
The brokerage industry became more competitive to increase earnings, and brokers began to give more leverage.
Imagine a broker willing to provide 99x power; it’s an investor’s fantasy!
You and the broker are likely to lose money in such a chaotic setup. Furthermore, if the broker has lent this much leverage to thousands of other clients, the odds of the broker failing are higher. (Sob-sob)
This isn’t a make-believe scenario. Many brokers have gone bankrupt by providing their clients with excessive leverage. You won’t believe it when I tell you that the number of broker defaults in 2020 was high, with many of them due to lower profits.
Before we talk about derivatives margins, it’s vital to understand the derivatives market and how goods make markets more efficient. Please read our blog on the many types of financial products.
We must buy shares in lots in futures contracts. It is not possible to buy futures on a single claim. As a result, traders must have a sizable bankroll to participate in futures. Retailers can’t afford to put a large chunk of money into the market upfront, so they use margin trading in lots.
When you buy a futures contract for the first time, you must keep a certain amount of money in your trading account, known as Initial Margin (IM). IM is a percentage of the contract’s total value. Nothing too difficult!
The initial margin (IM) comprises two parts: Span margin + Exposure margin.
The ‘SPAN Margin’ is the minimum margin required by the exchange, while the ‘Exposure Margin’ is the additional cushion. The SPAN margin requirement must be rigorously adhered to as long as the trader desires to carry his position overnight/the next day.
Mutual Fund Margin Trading
Because of its transaction mechanism, mutual fund units cannot be purchased on margin. Mutual fund units are not traded on the stock exchange. Mutual fund houses are where investors buy and sell mutual fund units. Only after the market closes, each working day are fund pricing decided. Margin trading mutual funds are not possible as a result of this limitation.
Good Margin Trading Techniques
- Invest Wisely: If you plan to trade on margin, you must proceed with extreme caution. When trading on margin, both losses and gains might be multiplied. If everything goes well, it’s okay. If something goes wrong, you’re going to be in a lot of trouble. Margin trading should only be used if you have enough funds to suffer a slight loss while still meeting the margin call.
- Borrowing Less Than the Maximum Permitted Amount: You should avoid borrowing the maximum amount permitted. To begin, start with a tiny amount and see how it goes. You can continue to margin trade if you are confident in producing good profits.
- Short-Term Borrowing: Margin is similar to a loan in that you must pay interest. To prevent paying extra interest, it’s essential to pay off the margin as soon as feasible.
Margin trading increases an investor’s purchasing power. However, if things don’t go your way, your losses may rise. You must be highly cautious while trading on margin.
Margin Trading Regulations by the SEBI
SEBI has established new margin requirements to increase transparency and protect investors’ interests. The following are some essential points:
- The new standard requires that an upfront margin be maintained at the start of the trade.
- Client margins are needed to be collected compulsorily in the Equity Derivatives segment.
- The initial margin, the exposure margin/extreme loss margin, and the mark-to-market settlements are all documented.
- An upfront margin will apply on both legs of BTST (Buy Today, Sell Tomorrow) trades (i.e. Buy and Sell).
Apart from the end-of-the-day margin check, which records the trader’s most significant open position in the market, the regulation of peak margin reporting went into effect on December 1, 2020.
This means that a trader must always keep an upfront margin, or a penalty will be applied.
The most straightforward approach to avoiding penalties in a margin trade facility is for investors to speak with their brokers about margins before executing a trade.
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What Are the Differences Between a Cash and a Margin Account?
You can pay for all of your stock transactions with cash if you have a cash account. With a trading margin account, you can borrow money from your broker to buy stocks. This comes at a cost, with advantages, disadvantages, and frightening repercussions.
The leverage is a benefit of buying stocks on margin. Investors can leverage up to 50% under current norms and restrictions. This equates to two-to-one force. You would quadruple your return for every dollar of stock movement upward.
Leverage, on the other hand, can be a double-edged sword. Your loss would be compounded for every dollar in stock price decline. If you borrow 50% of the stock purchase price and the stock price falls in half in a crash, you will receive short notice.
You will be requested to deposit more money into the account to carry the stocks. Your account will be liquidated if you do not comply by the deadline, usually three days. The broker will sell your equities on the open market to repay his margin- money you lent him. This does not rule out the stock’s possibility of recovering and beginning to rise again several days later.
The Stock Market’s Downfall Has a History of Trading Margin
The margin requirement was very loose during the Roaring Twenties. Investors were leveraging their way to the hills. Some borrowed up to 90% of the stock’s worth, similar to today’s real estate speculation. The market overheated, and the bubble burst despite the company’s lack of financial strength.
Everyone was looking for a quick buck. Panic selling began when the market finally swung south. Most investors could not put up cash, and margin calls were heard throughout the market. As a result, the Great Depression of the 1930s began.
Finally, be cautious while using a trading margin account because it is a double-edged weapon that can cause harm if utilised incorrectly.
Margin as a Short-Term Credit Source
A margin loan, which can be utilised for short-term financing, can be secured by stock in your account. For example, if your stock portfolio is worth $100,000, you might withdraw $30,000.00 from your margin account to cover various liquidity needs.
“Margin interest rates can be competitive, and in certain situations lower than other lending products,” says the author. According to Jennings, “A margin account can be used for a variety of purposes as long as you stay above your equity level.” “With margin, you get fast access to funds with no extra paperwork fuss, and there’s no set repayment period like with credit cards,” Woodward added.
Margin Mistakes You Should Avoid (i.e., Margin Pitfalls)
One common margin blunder, according to Jennings, is entering a transaction or position “completely extended.” In other words, if you have $100,000 in the available margin, it’s not a good idea to use it all. Both Jennings and Woodward warned about “overleveraging.”
“Leaving extra buying power as a reserve in case markets move against you can be advantageous,” Jennings said. “This has two possible benefits: it lowers your risk of a margin call, and the residual buying power can be used to buy more shares if prices fall, thus lowering your cost basis.”
“Even if it’s only one position,” Woodward warned, “if you’ve leveraged yourself too high and that trade goes the other way, it may put you in a margin call and wind up being very costly.”
Margin can assist traders and investors in achieving their investment goals when handled correctly. However, it is critical to comprehend the dangers thoroughly.
Margin trading raises the risk of loss and may result in a forced sell if account equity falls below the required thresholds. Not all account types allow for margin. Margin trading privileges are subject to inspection and approval by TD Ameritrade.