To ensure a stable future and meet monetary needs, it is essential to start investing. This can help individuals access capital gains if the price of the security rises, whether it is from stocks or an Exchange Traded Fund (ETF).
Investing in high volumes is beneficial, but few people face some kind of barriers that create difficulties in the process. Common obstacles include being too busy, it being a riskier option, and various other reasons. However, one of the most significant barriers is not having sufficient funds to purchase shares in large quantities.
Read this blog to get an in-depth knowledge of it, which includes margin trading definition, how it works, benefits, and risks associated with it. Moreover, this blog also guides you in starting margin trading efficiently.
Margin Trading Definition
Margin trading allows investors to buy stocks beyond their financial capacity. With the help of this process, they can increase their buying power while investing in the stock market. By borrowing funds from a particular stockbroker, investors can buy the shares with a marginal cost, rather than buying them for the original market value.
Since the broker is responsible for financing the remaining purchase amount, they charge interest on the loan to the investor. When you use margin to buy a security, you are essentially using the securities already available in your demat account as collateral for the loan.
As a result, this collateralised loan charges a regular interest which investors must pay as a repayment. This type of trading is beneficial in some particular situations, where investors earn a higher rate of return on the investment than paying the interest on the loan.
In MTF trading, a stockbroker will charge you interest for lending the funds needed to purchase stocks. Additionally, you can leverage your market position to meet the margin requirements, as you will need to provide collateral as security.
How does Margin Trading Work?
Margin trading allows investors to borrow money from a broker in order to purchase shares, amplifying their buying power. Here is a step-by-step explanation of how it works:
- Activate the Margin Trading Facility (MTF)
You can enable Margin Trading Facility (MTF) through your broker if they offer it. If not, consider switching to platforms like Torus Digital, which provides investors with the option to leverage MTF by increasing their purchasing power and maximising their investment potential!
- How Margin Trading Works witty Example
Once you activate this facility, it is time to understand the process of buying shares using MTF.
For instance, you are willing to purchase shares of company XYZ worth ₹1000, but you have only ₹200. In this case, you are going to offer 20% amount of the shares’ total market value as margin to the broker.
The SEBI guidelines will verify the details of this purchase under MTF. Since the broker funds the remaining 80% amount which is ₹800, you can now purchase shares worth ₹1000 with only ₹200 as collateral. Now, considering the situation of taking a personal loan, here comes the aspect of interest rates.
- Interest Charges
Since your broker lends you the money, they charge interest on the borrowed amount (₹800). Different brokers have different daily interest rates. This interest is either deducted from your profits or added to your losses.
- Profits and Risks
Coming to the profit and loss aspect, you can encounter a high-risk and high-reward situation.
Sticking to the example, the price of the shares rises to ₹1100 on the same day. If you had bought the shares with the original price, you would have got a 10% return. However, since you have opted for margin trading you can easily get more than 10% return from this investment, even after paying the interest.
On the other hand, you can encounter huge losses if the market crashes while using this process. If the share price of company XYZ decreases to ₹600, your loss would be ₹200. Since you only invested ₹200, you will lose your entire ₹200 investment, and the broker may ask you to repay the remaining ₹200.
Benefits of Margin Trading
Using margin trading, traders can get numerous benefits. Here are some other advantages of MTF trading that you need to look for:
- Using Collateral: You can leverage collateral such as cash and securities in your portfolio while borrowing money from the stockbroker. While purchasing securities on margin, collateral secures your loan and reduces the risks taken by lenders.
- Useful for Short-term Capital: When facing a shortage of funds, margin trading can allow individuals to gain in a shorter time frame.
- Options to Carry Forward: You can also avail the benefit of carrying forward the margin-brought positions up to the number of days from the trading day. However, different stockbrokers determine how many days you can carry forward the positions.
- Higher Returns: When the market goes bullish, your margin also appreciates, which you have put up as collateral. This allows you to buy more securities on margin.
Drawbacks of Margin Trading
While margin trading has its benefits, it is important to be aware of its potential drawbacks. Below are the key risks investors should consider:
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- Risk of Significant Losses: Investors must have an understanding of the associated risks of significant losses. The possibility of losses is also high since they have to pay an additional amount for accrued interest.
- Minimum Balance: While using the margin trading facility, you must keep the minimum balance. This can restrict you from collecting a significant portion of your capital. Moreover, investors should maintain a minimum account balance by letting go of a portion of their security holdings and or by depositing some cash.
- Liquidation Issues: If your trades perform poorly after taking a margin position, your account balance may fall below the required minimum margin level. As a result, a margin call will be triggered. If you fail to meet this call by depositing additional funds or securities, your broker may liquidate your assets to recover their loan, often resulting in significant losses.
- Interest Costs: Since borrowing funds for MTF trading include interest charges, your profits can be hampered, if not managed properly. You have to pay more interest, if you hold your leveraged position for a longer time. Nevertheless, if your investments do not perform well, these interest costs can hamper your gains.
- Regulatory Risks: Margin trading is governed by strict market regulations, which can pose significant risks if not properly understood. Without a thorough understanding of these rules, you might inadvertently violate them, leading to penalties or trading restrictions. To mitigate this risk, it is crucial to stay informed about the regulatory framework and ensure full compliance in all MTF trading activities.
How to Start Margin Trading?
Since you get familiar with what margin trading means, you need to learn how to start margin trading. Follow these steps to place a buy order using MTF trading:
Step 1: Once you have activated the margin trading facility, select a stock of your choice listed on the market under securities for MTF and place a buy order.
Step 2: After entering the quantity and your desired price, click on the buy option.
Step 3: When you receive a pledge request in your email, you must accept the request within a specified timeframe.
Step 4: Click on the link that has been shared with you and share the details of the required documents.
Step 5: Generate and enter the OTP for verification, to complete the final step of margin trading.
Final Thoughts
It is crucial to have a deeper understanding of margin trading, as it allows investors to buy securities beyond their financial capacity. With the proper knowledge of margin trading’s meaning and its benefits, investors can efficiently improve their financials.
Each broker charges different interest rates which accrue over time, while providing the loan amount. Investors should analyse different brokers before activating the MTF trading from one broker.
However, investors need to be aware of the rewards as well as the risks of using it. While investors can avail higher returns in a bullish market, they can also face extreme losses in a bear market, in addition to repaying the interest.
