What is Margin Trading? (Include real life exmaples from Angel Broking)

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In this module, we will understand about trading. Let us say you want to trade in the market and invest your money. You would require a margin account for doing so. To understand what a margin account and how can you employ it, let’s know what a margin is?

In layman's language, the difference between the price of the selling price of a service and its cost of production is called the margin. We can say that it is the ratio of profit to revenue. This means then whatever the difference will be between the total value of securities held in the account of the investor and the value of the loan amount of the broker.

When you buy something on margin it means that you are borrowing money to purchase the securities.  For example, if you are a buyer when you're buying an asset on margin, then you will pay a percentage of the value of the asset and borrow the rest of the money from a bank or broker. Here, the broker is a lender and the securities in investors' accounts are the collaterals.

Why do traders choose margin trading?

Now the question arises why do traders opt for margin trading? Let us understand this with an example - let's say with a sum of rupees 1,00,000 you can buy shares of XYZ limited in the cash market at the rate of rupees 1000 per share. For this transaction, you have to deposit a margin of 30% of the value of your outstanding position as per the margin trading in the derivatives market. In this scenario, you will be able to purchase shares of this company at the same price as your capital of rupees 1,00,000.  

The calculation for this would be:

Rs 1L / (30% of Rs 1000) = 300 shares

So, in effect, you are allowed a calculated of 3.33 times in this case (100/30). If the price of ABC Ltd. rises by Rs 100, your 100 shares in the cash market will deliver a profit of Rs 10,000, which would mean a return of 10 per cent on your investment. However, your payoff in the derivatives market would be much higher. The same rise of Rs 100 in the derivative market would fetch Rs 30,000, which translates into a whopping return of over 33 per cent on your investment of Rs 1L lakh. 

So, you get the leverage resources to buy more stock quantities; then you can afford at any point of time with a margin account. With margin trading, you get to purchase more shares than the cash in your account, using the funds borrowed from the broker. 

What is the process of margin trading?

The process of margin trading is quite simple. For doing so, the broker who's lending the money would buy the shares and keep them as collateral. Let's discuss its process:

Step 1- To be able to trade with a margin account, you are required to request a broker to open a margin account for you. You will have to pay a certain amount of money upfront to the broker in cash which is called the minimum margin. The broker uses the minimum margin to recover some money by squaring off. The broker uses the minimum margin in the case when the trader loses the bet and is unable to recuperate the cash. When the account is open, you will have to pay an initial margin (IM). IM is a certain percentage Of the total traded value which is predetermined by the broker. Keep in mind to maintain the minimum margin (MM). On a very volatile day, there's a chance that the price of the stock will fall more than you would have anticipated. You will have to maintain the minimum margin throughout the session for such incidences.

For example- if Whirlpool stock priced at Rs. 500 falls by  5%. The IM and MM is 8% and 4% of the total value of the shares, respectively. Then the trade-off 8% - 5% is equal to 3%, which is less than the MM. In such a scenario, you will have to pay more money to the broker for him to maintain the margin or the trade will be squared off automatically by him.

Step 2- At the end of every training session, you will have to square off your position. You will have to sell the shares if you bought them and if you've sold the shares in a session, you will have to buy them at the end. 

Step 3- For converting it into a delivery order after the trade, you will have to keep the cash ready to buy all the shares which you have purchased during the session. You will also have to pay the brokers fees and additional charges.

What amount of money is required for a margin account?

How much money do you need for a margin account? 

As per the guidelines of SEBI, you will have to maintain 50% as initial margin and 40% as maintenance margin, which is to be paid in cash if you want to open a margin account.  Let's have a look at what is the initial margin and maintenance margin.

  • Initial margin: the minimum amount which is calculated as a percentage of total investment is called initial margin the broken will use initial margin to fulfil the full settlement obligation.
  • maintenance margin: the minimum amount which the client is required to maintain in the margin account is called the maintenance margin. It is calculated as the percentage of market value as per the latest closing price of the securities which are forwarded as collaterals.

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Margin trading in commodities

In case you want to trade in Commodity Futures and options in Commodity Exchange like Multi-Commodity Exchange (MCX), you can opt for a margin account. While trading in commodities, the margins are generally lower- around 3% to 5%.

As a trader, through leverage, you can take a significant position in Commodity Futures and options. The leverages can have room for profits and also can leave you open to substantial losses. This is true in the case of commodities whose prices are volatile compared to the prices of stocks.

Now when we have understood what margin trading is, let's understand different types of margins. 

There are many ways in which the margins are calculated on the cash market segment of the Stock Exchange. There are three methods to do so- Value at Risk (VaR), Extreme Loss and Mark to Market margins.   

  • VaR margin: Based on loss of historical price trend vitality of the stock, we estimate the probability in VaR margin. This is one of the most commonly used methods, and it covers the most considered percentage loss incurred by an investor with a confidence level of 99% for shares on a single day.
  • Extreme Loss margin: In the situations that are not covered under VaR the margin, extreme loss margin covers the expected losses. 
  • Mark-to-Market margin (MTM): At the end of the trading day, MTM is calculated on all open positions. It is calculated by comparing the transaction price of the share for that day with the closing price.

Benefits of a Margin account

There are various benefits of a margin account which you can enjoy as a trader, let us understand them.

  • You can leverage your existing stock to make a further investment using the margin.
  • As a benefit of a margin account, you can avail loan against cash investment.
  • In the case of a declining market, you can earn profit using margin for short selling.
  • You can diversify your concentrated investment portfolio by using margin accounts to amplify your investment capacity.
  • When the initial investment amount is large, a margin account can also be used to invest in the F&O market.
  • If the amount of debt is not more than the initial margin, then you can pay back at your convenience.

Is margin trading right for you?

Now when we have understood what margin and margin account is, let us know if it is the right option for you. Before opening a margin trading account, you should understand your needs and investment goals. Margin trading has many advantages, yet it offers significant scope for profit and losses. You should keep the following points in check if you want to consider margin trading:

  1. You must have a high tolerance of risk.
  2. You must be able to keep cool in volatile situations.
  3. You must not go overboard on leverage.

The investors who are conservative with a low tolerance of risk should not consider margin trading.  Margin rating is best suited for short term trading in favourable conditions. When you have reliable information about a company that can affect its share price, that is when margin trading works as it will allow you to have higher exposure in that company to make more profit. Margin trading is not recommended to use margin trading for long term speculative trades.

Recap:

  • The difference between the price of the selling price of a service and its cost of production is called the margin.
  • With margin trading, you get to purchase more shares than the cash in your account, using the funds borrowed from the broker.
  • As per the guidelines of SEBI, you will have to maintain 50% as initial margin and 40% as maintenance margin which is to be paid in cash if you want to open a margin account.  
  • Margin trading is for short-selling and is not recommended for long term speculative trades.

Wrapping up

Now that you understand Margins, it’s only logical that we move on to the next big topic - Margin calculators and how they work. To discover the answer, head to the next chapter. 

A Quick Recap

  • Margin is the money borrowed from a broker to purchase an investment and is the difference between the total value of investment and the loan amount.
  • Margin trading refers to the practice of using borrowed funds from a broker to trade a financial asset, which forms the collateral for the loan from the broker.
  • A margin account is a standard brokerage account in which an investor is allowed to use the current cash or securities in their account as collateral for a loan.
  • Leverage conferred by margin will tend to amplify both gains and losses. In the event of a loss, a margin call may require your broker to liquidate securities without prior consent.
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