Margin Trading: Meaning, Types and Risk

The previous modules familiarised you with stock markets, the roles played by various financial intermediaries, and the different investor types. Now, to get you closer to the actual process of investment, in this module, we will dive deep into margin trading. It is one of the most popular types of trading where an investor can borrow money from their stockbroker to purchase an asset that they can’t otherwise afford.

What is margin? 

Also known as leverage, margin refers to the amount of money you can borrow from your broker in order to make trades in the market. Securities which can be bought by using margin are known as marginable securities. 

For example, if you have securities worth ₹1 lakh in your account and your broker offers a 40% margin limit, you can borrow up to ₹40,000. The margin percentage also depends on the associated risk. 

What is margin trading? 

It is a strategy where you, the investor, can borrow capital to improve your trading position’s size. You can trade with more money than what is there in your account. The financial asset that you buy with borrowed funds becomes a part of your MTF-based securities, and hence, collateral. With margin trading, you can amplify profits if your prediction about the asset’s price is right, but lose more if your prediction is wrong.   

Let’s explore margin trading in more detail. 

Types of Margin Trading 

India’s margin trading landscape is regulated by the Securities and Exchange Board of India (SEBI). Before getting started, it is crucial to know about these two processes – margin pledging and margin trading facility (MTF) pledging. MTF accounts are offered by many financial institutions and brokerage platforms.  

Margin Pledging 

• Involves using the current securities in your Demat account as collateral to obtain extra margin
• Similar to a mortgage loan 
• You can pledge securities anytime you want to enhance the additional margin 
• Stocks, mutual funds, ETFs, and sovereign gold bonds can be pledged 

Margin Trading Facility (MTF)

• This involves a trader borrowing money from the broker and using the borrowed funds to place trades. The difference between the net realised profit and the interest paid on the MTF becomes the earnings of the trader.
• When you purchase shares under MTF, you must pledge them before 9 PM on the same day to hold the position 
• If you don’t adhere to the pledge timeline or experience a margin shortfall, an automatic closure of your position will be triggered on the eighth day from the day of purchase
• Only approved equity shares can be pledged 

Common Types of Margin Trading in our country include:   

• Intraday margin trading:

You can use margin to boost your trading position and capitalise on price fluctuations in the short run and on the same trading day. Positions close before the market closes. 

• Delivery margin trading:

You hold the position for more than one trading day and can use the margin to accept the delivery of shares. 

• Short selling:

Using margin can help you sell stocks that you don’t own and purchase them back at a lesser price in the future. If the price increases, the margin can cover potential losses. 

• Futures and options margin trading:

You can use margin in the derivatives market to trade futures as well as options contracts and create a position that assures decent profit and minimal risk. 

• Arbitrage trading:

Margin can be utilised to capitalise on price differences between different exchanges or markets, thereby improving the chances of better returns. 

• Pairs trading:

You can use margin to assume a long position (where you own the security, expecting its price to rise later) and a short position (involves selling a stock you don’t own as you expect its price to fall shortly) at the same time in two stocks that are correlated. You can reap profits from the difference in their price movements. 

• Event-led margin trading:

Economic data releases, announcements of earnings, and corporate actions can trigger market movements. By using margin, you can make the most of them.

Margin Trading on Angel One

Angel One offers a convenient and secure margin trading facility. With this, you can:

1. Trade with greater capital: Increase your buying power and trade with more than what's currently in your account.
2. Short-sell stocks: Do short-selling when you anticipate a decline in the stock price.

Open an Angel One account and explore the exciting world of margin trading! However, proceed with caution as margin trading is a high-risk strategy. Carefully consider your risk tolerance and investment objectives before using margin.

How to Use Margin Trading?

Margin trading usually involves these steps:

Step 1: Open a Margin Account

• Select a brokerage that provides margin accounts.
• Complete the application by submitting information on your investment experience, risk appetite, and financial condition. 

Step 2: Learn Important Terms

• Initial margin – A specific percentage of your total position value, as decided by the broker based on asset type and regulatory requirements. You must deposit it when opening a margin position. 
• Maintenance margin – The level of equity you must maintain in your account. 
• Leverage – It involves borrowing funds that help you control a bigger position than what your own capital enables. Leverage is denoted as a ratio. So, a 2:1 leverage means you can create a ₹20,000 position with a deposit of ₹10,000.  
• Margin call – This refers to the broker’s demand for extra funds if your equity drops below the maintenance margin. If you don’t answer a margin call, the broker can cover losses by liquidating the position partially or completely.

Step 3: Deposit Initial Margin

• This is a percentage of the total worth of your trading position. 

Step 4: Place a Margin Trade

• Pick a financial instrument.

• Decide on the position size based on the leverage ratio. 
• Use the broker’s platform to place the trade.

Step 5: Manage the Trade

• Watch out for news, factors, or market conditions that might impact the asset’s price.
• Set stop-loss orders to manage risk and minimise losses. 

Step 6: Meet Margin Call Requirements

• Ensure your account equity stays above the maintenance margin. 
• If you get a margin call, immediately deposit extra funds. 

Step 7: Consider Interest Charges

• In a margin account, borrowed funds attract interest charges.
• Assess the effect on your overall trading cost. 

Step 8: Stay Informed 

• Learn techniques for market analysis and risk management.  
• Watch out for updates from your broker.
• Review your trading position periodically. 

Trading Instruments that are Eligible for Margin Trading

Now that you know the meaning of margin trading and how to go about it, let’s look at the financial instruments that can be traded this way. 

• Stocks – You can use margin trading to control larger positions and boost your purchasing power. 
• Bonds – You can enhance your exposure to fixed-income securities with margin trading. 
• Foreign exchange – With margin trading, it is possible to control bigger positions while trading in currency pairs. 
• Commodities – Margin can help you magnify trading positions, whether you are dealing in metals, agricultural products, or energy commodities. 
• Futures contracts – Margin is widely used in futures contracts involving commodities, interest rates, and stock market indices. 
• Options – If you employ sophisticated strategies that involve the sale of options contracts, the margin might come in handy. 
• Exchange-Traded Funds (ETFs) – You can control larger positions in a portfolio that is diversified by trading ETFs on margin. 
• Real Estate Investment Trusts (REITs) – It is possible to trade REITs on margin with certain brokerage platforms. 

We will now explore the pros and cons of margin trading. 

Benefits of Margin Trading

Here’s an example that highlights the key benefit of margin trading. Say Mr Z buys a stock worth ₹80. At the time of position closing, its price rises to ₹90. If Mr Z buys the stock with cash and pays in full, he will earn a return of 12.5% on his investment. However, if he makes the purchase via margin trading and pays only ₹30 in cash, the return will be 33.33% (10/30 * 100). Thus, margin trading offers the scope to profit more. 

Let’s shine the spotlight on its advantages: 

• You can profit from short-term fluctuations in stock price even if you don’t have adequate cash to invest. 
• If you purchase securities on margin, you can leverage the value of those securities that you already own to enhance the investment size. 
• Margin trading allows small traders to perform short selling, i.e. selling an asset and then buying it back before the end of the day. Through short selling, you can profit even when an asset’s price goes down. For instance, you spot a company called ABC that is likely to see a drop in price within a day. You can sell 1,000 call option contracts at ₹50 each (total ₹50,000) by using MTF, i.e. getting a ₹50,000 loan from your broker. After a few hours, when the share price falls, bringing the option price to ₹40 per contract, you buy the 1,000 contracts for ₹40,000 and return them, as well as the ₹50,000 (plus interest) that you had borrowed from the broker. The difference of roughly ₹10,000 is your profit. Short selling can be done with stocks as well.

• Margin trading diversifies your portfolio. For example, if you own too many stocks from only one company, you can use them as collateral to get a margin loan. The proceeds from the loan can be used to diversify the portfolio without selling the original shares. 
• Since SEBI closely oversees margin trading, you can expect transparency and fairness. 

Risks of Margin Trading 

To understand the core risk of margin trading, let’s again look at the example of Mr Z. What happens if, instead of rising, the stock price falls from ₹80 to ₹40? If Mr Z buys the stock with cash entirely, he will incur a loss of 50% on his investment. However, if he uses margin trading, his loss will exceed 100%. 

So, what are the main disadvantages of margin trading? 

• You might end up losing more than what you invest. 
• You must maintain a minimum balance (maintenance margin) in your account all the time. If the balance dips below this point, you might have to deposit more cash or sell from the stocks you own. 
• Brokers can liquidate your MTF assets to cover their losses if you don’t stick to your end of the agreement.  

Tips to Trade on Margin Wisely 

Now that you have a fair idea about what is trading on margin, here are a few tips to help you maximise returns and minimise risks: 

• Margin trading is ideal if you have enough cash to withstand any scaled-up losses from MTF-based trading. 
• Avoid borrowing the maximum allowed limit. Instead, trade with a small upfront amount and see how things go. 
• Since the margin is a loan, settle it as soon as possible to avoid paying high interest. 

Wrapping Up

Margin trading comes with both pros and cons, and it might take you some time to gain the necessary experience and expertise before you can confidently profit from it. Remember to assess your financial situation, risk profile, and investment objectives too, before going for margin trading. 

In the next modules, we will explore trading further and touch on aspects of technical analysis.