If you were to buy 1000 shares of Reliance Industries in the market, it will cost you nearly Rs.10 lakh to take delivery of that stock. Suppose, you did not have that kind of money, what can you do? That is where margin trading and margin funding come in handy. So, what is margin trading and what are the risks associated with margin trading. Why should trading on margin be avoided or at least the risk should be managed very efficiently. Before we get into the discussion on margin trading, you need to remember that there are two kinds of margin trading that exist in the market. Both are different and you need to understand the risks involved in them separately.
Margin trading purely for intraday purpose
This is the most common form of margin trading that most of us indulge in. In the above case, if the trader wants to buy Reliance only for intraday trading purpose then he need not bring in the full money. Brokers will typically give you margin up to 4-5 times your margin money based on the volatility of the stock and the risk involved. So in the above case, you can buy 1000 shares of Reliance for intraday by putting in a margin of around Rs.2.50 lakh. With that margin you will be allowed to purchase 1000 shares of RIL strictly for intraday purposes. To avail this intraday trading margin, you need to clearly specify that you only want to buy the stock for intraday. In fact, if you also put a stop loss and profit target at the time of placing the order then it becomes a cover order/bracket order and can give a still higher margin. The condition is that these intraday trades must be closed out intraday. Normally, brokers run their open position MIS at around 3.00 pm and if the trader does not close the intraday position by 3.10 pm then the broker’s online RMS will close the position.
Margin funding for delivery positions
Here you actually take a position in the stock for delivery and you are not required to close out the position intraday. Suppose in the case of RIL, you pay 25% margin to buy 1000 shares of RIL. Next day morning the pay-in has to be done. In this case, the pay-in will be done on your behalf by your broker. Since the broker cannot finance the transaction, this margin funding is normally routed through the NBFC arm of the broker. Of course, the broker will charge you interest for the time period that you use the margin. The margin funding position will automatically get closed when the shares are sold.
Five precautions you need to take in margin trading
Margin trading has some in-built risk management mechanisms that are built in. However, here are few precautions that you must take while taking a margin trading position.
If you are trading on margin for intraday then stop loss is a must. You cannot get into a position and then wait for an opportune moment to put the stop loss. It has to be part of the order. More importantly you must maintain the discipline of stop loss and not try and average positions if the price moves against you.
The second thing about margin trading is to have a discipline with respect to profit booking. In this business, profit is what is booked; all else is just book profits. Keep churning your capital and try to reduce the turnaround time for your positions. That is your best bet against market volatility.
Take ownership for your margin trading position. Don’t leave it to the broker to close out the position because the broker will close it with a program. You may not get a good price in that case. Set a time limit and close out within that time limit. More importantly, take the responsibility for monitoring your margin trading positions.
When you are taking margin funding avoid stocks that are too volatile or that are too static. Either ways you run the risk of losing money. A static stock will hardly give you any movement but your interest bill will keeping going up. In cases of volatile stocks your losses can be triggered either ways.
Don’t get into a margin funding position without calculating the cost and the effective breakeven point for your position. There are other costs to the margin funding like administrative charge, DP charges and processing charges which are in addition to interest. Also consider the statutory cost and then work out the break-even. You can then take a clear call on whether the margin funding position is worthwhile or not.
Margin trading and margin funding are good ways of leveraging your limited capital. But it is always better to have your precautions and safety net in place.