In the stock market, it is easy to gain money, provided you have the smarts and strategies in place. In the same way, you may lose money by betting on the “wrong” stock, which may happen for a number of reasons, like not having done your research properly, or jumping on the bandwagon of other investors’ stock choices. Whatever experiences you face in the stock market, and before you even face them at all, you may find that you don’t have funds to purchase stocks when the opportunity presents itself. Margin trading funding can help you to buy shares that you want, and gain from any potential profits. An example can help you to understand why you may want funds. This is the background of margin trading in the stock market.
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. Before getting into those clarifications, you need to grasp some more basic knowledge on margin trading.
When investors cannot afford to buy stocks they wish to, or end up purchasing more than they can afford, margin trading helps them to buy shares and pay for them later. How? First of all, it is important to note that margin trading is mainly done for trades that last within a trading day. Furthermore, a range of reputed brokers provide the service of funding investors. Technically, margin trading relates to the purchase and sale of stocks in a single session. However, nowadays, to encourage more trading activity, the duration of squaring off trades has been relaxed by brokers.
The process is not a challenge to understand. If you are an investor, and do not have the funds to purchase any stock, a margin account gives you the funds to do so. Therefore, a broker essentially gives you a loan to buy stocks that you cannot buy at any point of time. The margin trading facility is given to investors and brokers keep the bought stock as collateral. The process starts with a request to your broker to open a margin account in which you have to deposit a minimal amount of cash to start the service. These days, as brokers wish to engage more traders, an e-margin facility is given to investors. With this, investors and traders can buy shares with leverage, and carry their positions for up to a year of trading days. Investors can, during that time, either opt for a delivery margin and get stocks into a demat account after squaring off the broker as soon as funds are available, or square off later on.
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.
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.
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.
Still, with margin trading, the advantage is that small investors get to trade and pay off brokers by having time to accumulate the margin money. This gives small investors the power to handle the sock market and gain some experience. The facility does have some pitfalls, as if investors overextend themselves, they may lose more in the bargain. Therefore, like any seasoned analyst will tell you, even with margin trading, you should start in a small way. This ensures you can square off trades within a day or in the case of an e-margin, within your stipulated duration.