I have come across many people who are very interested in margin trading but often suffer because of lack of knowledge. It was yesterday only when a student of finance approached me, she wanted to know more on margin trading so that she can even start investing in stock market and earn her pocket money on her own. Her queries prompted me to write an article on the subject so that it can help the readers.
To be begin with, let us get a hold on as to what exactly margin trading is. Margin trading is also known as buying on margin. In this method, the trader buys the shares by borrowing a part of the total sum from the broker who will execute the transaction. The broker will lend this amount to the trader on the collateral security of the shares in trader’s account. For example – An investor wants to purchase 1,000 shares of Rs. 100 each, then for a position of Rs. 1, 00,000, a broker may offer the investor with 50% margin funding, i.e. for Rs. 50,000 and the remaining Rs. 50,000 has to be arranged by the investor as margin money.
The trader or investor is usually required to deposit an initial amount in the margin account with the broker. This amount can either be in the form of cash or it may be in the form of securities. This amount is known as initial margin. And thereafter, the investor will have to maintain a minimum margin as per the minimum margin requirements of the account. Whenever the amount in the margin account falls short of the minimum requirement, the broker will make a margin call to the investor for the additional funds. The margin amount required to be maintained in the margin account keeps fluctuating as per the market values of the stock. For example – the market value of the stock goes up at Rs. 103 in 30 days, the investor will repay Rs. 50,000 with interest and will keep the remaining amount in his pocket. However, if the price will fall to Rs. 98, then the investor will lose Rs. 2 per share plus interest and Rs. 50,000 will also have to be repaid to the broker.
The major risk of dealing with this method is that in case the market falls and the stock prices witness a dip, the investor will suffer from a capital loss and he will also be bothered with the margin calls from the broker.
How one can successfully do margin trading?
A margin trading is a form of leveraging for an investor in the stock market. You can follow the following tricks to make a successful use of the margin trading:
- Compare the interest rate – Just like there is an interest rate that needs to be paid on the loan from banks, you will have to pay an interest on margin trading to the broker. Normally, stock broker charges 8% interest per annum on the fund borrowed from them. Therefore, if you can find a person who can lend you at a lesser rate than this then you have to make your choices rationally.
- Buy in Phases – One should not buy stocks in one go, rather be patient and buy in phases. This will give you an added advantage of rectifying your mistakes that you have previously done and will be greatly helpful in reducing the adverse impact of ups and downs in the market.
- Read the broker guidelines carefully – Don’t get involved in margin trading if you do not understand the game and its rules clearly. At least you need to be more careful while making your first margin trading transaction.
- Know the risks of margin calls – Though you may not like to get a margin call from your broker as it requires you to arrange and deposit the additional money in margin account with the broker, but you will still have to face it if the stock prices fall. Otherwise, the only option left with you will be to sell off your holdings. For that reason, margin trading is not good.
- Make a use of stop loss orders – Stop loss orders is a wonderful tool in the hands of investors to limit their losses. You can consider it like an insurance policy.
- Be vigilant – If you have transacted through margin trading then you need to be more cautious and vigilant of any news coming in relation to the market and your stock. This is so because a major market or stock update may have an impact on the market price of the share and accordingly the margin requirements will undergo a change.
In addition, have back up funding always ready with you.