In the fast-growing financial world, margin trading is a term that often catches the attention of investors and traders looking to amplify their potential profits. However, its potential benefits come with inherent risks that require a thorough understanding.
This trading process involves borrowing funds from a brokerage firm to trade positions larger than the investor’s account balance allows.
This practice can significantly magnify wins and losses, making it a tool that requires careful consideration. This comprehensive guide will delve deeper into the mechanics, benefits, risks, and strategies involved in margin trading.
What is Margin Trading?
It is a trading process in which an investor can buy more shares than they can buy with their current money. In this case, he can buy the stock by paying a small amount compared to the actual value.
You have heard the news that it is supposed to increase a company’s stock price shortly. You want to buy 100 shares of this company and hold them for a month, but your available funds only allow you to buy 30. Can I buy all 100 shares now?
To benefit from Margin Trading Facility, or Margin Trading Funding (MTF), an investor must request their broker to open an MTF account. A minimum balance (called minimum margin) must be maintained in the margin account. The broker specifies this. Before trading, the investor must deposit a certain percentage of the total transaction value, and the broker funds the rest. The broker charges interest on the full MTF positions created by the client.
How Does Margin Trading Work?
After opening an MTF account, the broker can fund the client’s trade after the client places an order under the MTF and pays the required margin. The amount financed is the same as the borrowed capital, which the investor will pay interest.
For example :
An investor wants to buy shares worth Rs 50,000 but still needs the total amount. He can pay part of the total amount to buy the stock, called the margin. Let’s say the margin, in this case, is 25%. So the investor pays the broker Rs 10,000 (25% of Rs 40,000) as a margin. The investor is required to pay the broker interest on the total MTF position created.
Eligibility for Margin Trading
As an investor, you must have an MTF account with a broker to benefit from the MTF facility.
The broker sets a minimum maintenance level, which must be maintained when trading with MTF. If you do not maintain it, your transaction will be cancelled completely.
Before squaring, the broker prompts you to add capital to the margin account to reach the minimum maintenance level via a margin call. If it is added, the position will not be resolved, and you can keep it.
Advantages of Margin Trading
1. Increased Buying Power
One of the primary benefits of this trading is the ability to control a more prominent position than feasible with only the investor’s capital. This increased buying power can lead to higher potential returns.
The process enables investors to diversify their portfolios beyond what their available capital might allow. It can expose a broader range of assets and potentially reduce risk.
3. Short Selling
Margin accounts also enable investors to engage in short selling. In this strategy, they can profit from the decline in the value of an asset.
Risks Involved in Margin Trading
1. Magnified Losses
While this trading can amplify gains, it can equally magnify losses. If the trade goes against the investor, they lose their capital and repay the borrowed funds, potentially leading to a significant financial setback.
2. Margin Calls
Brokers monitor margin accounts closely, and if the account’s value falls below a certain threshold (the maintenance margin), the investor will receive a margin call. The investor must deposit additional funds or sell assets to return the account to the required level.
3. Market Volatility
Margin trading in volatile markets can be hazardous, as price fluctuations can lead to rapid and substantial losses, potentially surpassing the initial investment.
In summary, this trading can be a risky but potentially lucrative strategy for online stock traders. It involves borrowing money from a broker to increase purchasing power and potential profits. Still, it also carries the risk of significant losses.
It is essential to understand the pros and cons of the process before deciding if it is right for you.