Do you gamble? You would’ve heard about blackjack. So if you’re sitting at the blackjack table and you have great cards. You want to increase your bet as you see great potential in the hand. But you realise that you’re a little short on cash. Lucky for you, you friend offers to pay now, so you can return later. This is a gamble as if you do make money, you’ll be able to return the amount to your friend and make profits too! But if you lose, you don’t just lose the money you had but you’re indebted to your friend too!
In this scenario, the stakes are high but subsequently so are the profits. Similarly, the risk is very high too!Now, we’re not saying that margin trading is gambling. But there are certain lessons to be learnt here.
Margin trading is a high-risk strategy that can yield a huge profit if executed correctly. But it has a flip side as this also means that you could lose your assets in the process. And if we’ve established the risk on margin trading appropriately, it’s better to go in with knowledge and a plan. Because if your strategy works, it can yield unfathomable returns. Revisit your notes on the basics of stocks before you go on to invest in margin trading. If you don't understand what stocks are, you certainly don't want to be buying them on margin!
What is margin trading?
Buying on margin is borrowing money from a broker to purchase stock. You can consider it a loan from your brokerage. If your money is limiting you to buy as many stocks as you’d like, margin trading allows you to expand your horizons.
To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. Your broker has to get your signature on appropriate documents to open a margin account, as per the law. The margin account may be part of your standard account opening agreement or may be a completely separate agreement.
Buying stocks on margin
You will have to make an initial investment known as the minimum margin. After completing the formalities, your account opens and is operational, you can borrow up to 50% of the purchase price of a stock. You can even borrow less, depending on your requirement. This sum is known as the initial margin. Some brokers might ask for more than 50% of the purchase price of a stock. Beware of such brokers.
When you sell the stock through margin trading, the earnings go to your broker against the repayment of the loan until fully paid.
There is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a margin call.
You can keep your loan as long as you want, provided you fulfill your obligations.But as we know you cannot borrow without interest, unless you’re borrowing from your best friend. You'll have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. You might get stuck in a loop as over time, your debt level increases as interest charges keep accruing. And as debt increases, the interest charges increase, and it goes on.
You don’t want to get into a long-term loop with such an investment. If you hold the investment for longer, you’ll need greater returns to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.
There are restrictions on the stock you can buy on margin trading. The Securities and Exchange Board of India regulates which stocks are marginable. As a general rule, brokers don’t allow customers to purchase penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin as the risks involved with these types of stocks is high. Brokers can individually decide not to margin certain stocks, so check with them to see what restrictions exist on your margin account. The buying power of a margin account changes daily depending on the price movement of the marginable securities in the account.