Margin Trading: Definition, Working, Advantages and Risks

If you are a trader looking to maximise your potential returns, there are many strategies that you can follow. One such strategy that you can consider using is margin trading. By adopting this approach, you can amplify your purchasing power and potentially increase your profits. However, like any trading or investment strategy, margin trading also comes with its own set of advantages and risks, which you need to thoroughly understand before using it.

In this article, we will delve into the meaning of margin trading, explore the working mechanism, and look into the various advantages and risks associated with it.   

What is Margin Trading?

Margin trading, also known as Margin Trading Facility (MTF), is a service that stockbrokers offer. It allows you to purchase more shares than you could with your available capital alone. This is done by borrowing money from the broker to fund a portion of the purchase.

The concept of margin trading revolves around two key components: your own capital, which is referred to as the margin, and the borrowed funds from the broker. The ratio between these two components is known as the margin ratio, which varies depending on the broker's policies and regulatory guidelines. 

Most Indian stockbrokers offer a 1:4 or 4X margin, which essentially means that you can purchase four times more shares than what you could have with your capital alone. For instance, say you have a capital of Rs. 10,000. With a 4X Margin Trading Facility, you can purchase shares worth up to Rs. 40,000 (Rs. 10,000 x 4 times) by simply depositing the Rs. 10,000 as a margin with your broker.  

To put it simply, margin trading is a form of leverage since it enables you to take larger positions in the market by simply depositing a small amount upfront. 

How Does Margin Trading Work? 

Now that you are aware of the meaning of margin trading, let us look at how it works with the help of a hypothetical example. 
Assume you have a trading and demat account with a stockbroker who also offers a Margin Trading Facility (MTF). The broker is willing to offer a maximum margin of 4X. Your current trading capital is Rs. 50,000. With MTF, you can purchase shares worth Rs. 2,00,000 (Rs. 50,000 x 4 times). 

Now, let us say that you want to invest in a promising tech stock that is likely to move up in price shortly. The current share price of the company is Rs. 900. To maximise your profit potential, you decide to use your broker’s MTF facility to purchase the shares. Since your total purchasing power is now Rs. 2,00,000, you can buy 222 shares of the promising tech company.

In exchange for borrowing Rs. 1,50,000, the stockbroker levies interest at a rate of 18% per annum. The borrowed amount, along with the accumulated interest, must be paid once you sell the 222 shares you purchased. 

However, since the price of stocks can fluctuate and move against your position, the broker will pledge the 222 shares you purchase. This is done to protect the broker from incurring losses due to a fall in the share price or non-payment of the borrowed amount.

Fortunately, the stock price moved as you expected and rose from Rs. 900 to Rs. 1,000 within 10 days from the date of purchase. At this point, you decide to liquidate your entire holdings, which gives you a profit of Rs. 22,200 (Rs. 100 x 222 shares). You repay the borrowed amount of Rs. 1,50,000 along with accumulated interest for 10 days, which comes up to Rs. 740 {[(Rs. 1,50,000 x 18%) ÷ 365 days] x 10 days}. 

The total remaining profit in your hand would be Rs. 21,460 (Rs. 22,200 - Rs. 740). 

Had you not used the Margin Trading Facility offered by your stockbroker, you would have only been able to purchase 55 shares (Rs. 50,000 ÷ Rs. 900), which would have limited your profits to just Rs. 5,500 (Rs. 100 x 55 shares).              

What are the Advantages of Margin Trading?

Leverage trading, such as through the MTF facility offered by stockbrokers, can be immensely beneficial to traders and investors. Here are some of the advantages of this facility: 

1. Increased Purchasing Power

The most obvious benefit of margin trading is the ability to purchase more shares than would have been possible with your investment capital alone. For instance, in the example mentioned above, you were able to purchase 222 shares of the tech stock with MTF as opposed to just 55 shares with your available capital.  

2. Potential for Higher Returns

If the stock purchased on margin appreciates in value, the returns can be significantly higher compared to what they would have been if you had only used your own capital. This can be seen in the example discussed above. With margin trading, you were able to get a profit of Rs. 21,460 compared to just Rs. 5,500.  

3. Flexibility

Margin Trading Facility can be very flexible. Many stockbrokers offer MTF with unlimited holding periods, allowing you to use the facility for short-term trading strategies and long-term margin investing. 

4. No Need to Sell Existing Investments

Margin trading allows you to access additional funds without having to liquidate your existing investments. With MTF, you can capitalise on short-term trading opportunities without liquidating your long-term investments.

What are the Disadvantages of Margin Trading?

Although margin trading has plenty of advantages, it also has a few risks and drawbacks. Understanding what they are is crucial for making informed decisions. 

1. Amplified Losses

While trading on margin can magnify gains, it can also magnify losses. If the shares purchased on margin decrease in value, the losses can quickly become quite substantial due to the larger position sizes. 

2. Interest Costs

The interest charged on the borrowed funds can eat into profits or increase your losses, especially if you hold your margin trading positions for a long period. Furthermore, interest costs will continue to accrue regardless of how the investments perform.

3. Margin Calls

If the value of the stocks purchased on a margin falls below a certain level, your stockbroker will issue a margin call, demanding that you deposit additional funds. If you do not meet the margin call within the stipulated time, your margin position will be automatically squared off, leading to losses or hardship. 

4. Increased Risk

The easy availability of the Margin Trading Facility could potentially tempt you to take on more risk than you can handle. This could lead quickly to significant financial distress.

Also Read: How to Select Stocks for Swing Trading?

Conclusion

Margin trading is a powerful tool that can significantly enhance your purchasing power and, consequently, your ability to generate profits. However, it is a complicated strategy that comes with substantial risks, including the potential for amplified losses and the emotional and financial stress of having to meet margin calls. 

To be successful at margin trading, you must have a thorough understanding of the mechanics involved, a strong grasp of market dynamics, and robust risk management strategies. It's advisable to start with a conservative approach, where you use margin sparingly. Once you gain enough experience and confidence, you can consider gradually increasing its use.