Investing and trading in stock markets have traditionally been considered to be risky due to market volatility. However, there is also another factor that often deters new entrants into the market and that is the lack of adequate finance. It is a fact that money generates more money and therefore when there is a shortage of finances, the returns will also be limited. While there are traditional modes of getting finances like loans to solve this issue, traders can also use the margin facility offered by brokers to ensure that they do not miss out on profitable trades due to a lack of funds.
So what is this margin trading facility and why is it so beneficial for traders? Given below is the meaning of margin trading and related details of the same.
What is margin trading?
Margin trading is a very common practice in intraday trading and is also known as MTF or margin trading facility. Under this facility, traders can take suitable trading positions by using funds provided by brokers against the collateral of their investments already held in their accounts. Earlier traders could get collateral against cash margin and not against shares.
However, after an amendment relating to the same, traders can now use many securities held in their Demat account like shares, bonds, Liquid Bees, Sovereign bonds, etc. as per the guidelines of SEBI and the policies of individual brokers. The quantum of margin provided to traders varies from broker to broker and also depends on the nature of security used as collateral. Furthermore, as per the current guidelines of SEBI, only corporate brokers are allowed to provide margin trading facilities to their customers.
How does margin trading work?
To use the margin trading facility, the traders will first have to pledge their intended security. This security is then held in a separate account by the brokers as collateral. The broker will keep a haircut from the total value of the pledged security (approximately 10%-20% depending on the asset and broker’s policies) and the rest can be utilized for trading, i.e. buying or taking the desired trading position in the open market.
This facility can be used by position traders and swing traders too as under margin trading, positions are closed on T+N days where ‘T’ is the day of opening the position and ‘N’ is the number of days within which such position has to be squared off. If the trader does not close their position within the designated days, the broker will square off the position and release the margin. If the trader has booked a profit on the trade, they can account for the same in their Demat account and pay the applicable taxes. On the other hand, if the trader has incurred a loss on their positions, and they do not have enough margin to cover the same, they will have to pay a penalty as per the guidelines of the broker.
What are the pros and cons of margin trading?
Margin trading facility is offered by all the eligible brokers to their customers to attract more business. Some of the benefits and disadvantages of this facility are highlighted below.
- Pros
A few prime advantages of margin trading facility are,
- Increase in the purchasing power of investors
Investors get access to larger funds through margin trading. This increases their probability to trade in higher volumes without the need to pump in their own funds. This facility, therefore, acts similar to loan funds and the interest charges for the same are also nominal.
- Increase in the net return on the portfolio
Margin trading can help in boosting the net rate of return on the capital employed and ensure that the overall profitability of the portfolio is higher. Traders enjoy the benefit of higher returns on limited investment and thereby the net profitability of the portfolio is increased.
- Better usage of securities held in Demat account
Earlier SEBI allowed margin trading only on the cash investment. However, now margin trading is available on securities held in the Demat account as well. This helps to make better use of the already held securities which were otherwise lying idle in the Demat account. It essentially works a
- Regulated format of investing
The format of margin trading is currently restricted to only corporate brokers. Also, there are many restrictions and guidelines in place by SEBI for this type of trading to secure the interest of the brokers, traders, and the market as a whole. This regulated format of trading reduces the risk of fraud as well as adds transparency to all transactions.
- Ideal for investors with a high-risk appetite
This trading facility is ideal for investors with a high-risk appetite but with limited access to their own funds. Also, trading with borrowed funds is a safer option than trading in higher volumes by taking a loan which may pose a financial crisis in the later stage. This facility lets them tap the right market opportunities and increases the probability to generate short-term gains.
- Cons
Some of the shortcomings of margin trading are,
- Maintaining minimum balance
For trading using the margin trading facility, investors need to maintain a minimum balance in their trading account at all times. If at any point of time this balance goes below the designated minimum balance, the broker will ask the trader to meet the shortfall as well as levy a penalty for failure to meet the same.
- Possibility of huge losses
Trading in stock markets is quite risky and trading using the margin facility is further riskier. The traders can end up losing their capital investment provided as collateral in the event of a loss. It is therefore important to first understand personal risk assessment and trade accordingly.
- Right of brokers to liquidate collateral
We have earlier mentioned that brokers have the right to ask the traders to maintain a minimum balance and also levy a penalty in case of not meeting this condition. On the other hand, if there are continual losses or if the traders do not meet the provisions of the margin trade agreement, the brokers have the right to liquidate their assets and recover their dues.
Conclusion
Margin trade facility is a very common facility that is used by almost every trader. This facility helps in increasing the trading volumes as well as the net profitability of the portfolio. The risk-taking ability of the investors and traders is also increased over time after good experience through margin trading. Hence, it is advisable that traders should use his facility with caution keeping their risk-return assessment in check.
FAQs
When the balance in the trading account is lower than the minimum maintenance margin, the brokers initiate a margin call. The traders are required to bring their balance back up to the minimum maintenance margin failing which the broker has the authority to liquidate the collateral to secure their funds or square off the positions at the current levels.
Margin trading facility can only be provided by corporate brokers.
The securities can be pledged for T+N days where ‘T’ is the day of opening the position and ‘N’ is the number of days within which such position has to be squared off.
Yes. Brokers charge nominal interest for providing a margin trading facility. This rate of interest varies from broker to broker based on their cost of lending and internal policies.
