MARGIN TRADING

WHAT IS MARGIN TRADING?

Margin trading is buying stocks without having the entire money to do it. The exchanges have an institutionalised method of buying stocks without having the capital through the futures market.
A method of buying shares that involves borrowing a part of the sum needed from the broker executing the transaction. The collateral for the loan is normally securities in the investor's account. The investor must deposit an initial amount of cash(down payment called margin) or securities (initial margin or margin requirement) into a margin account with the broker & can purchase stocks worth more, and must thereafter maintain a minimum amount of cash or securities (margin) in the account as collateral (maintenance margin, minimum maintenance or maintenance requirement). The broker charges interest on this loan(in addition to the commission on each buy/sell trade).The investor has to keep the entire stockholding with the broker as collateral. Also, the investor has to put up additional cash in case the value of the stockholding falls below a certain amount.

Margin trading is a double-edged sword it cuts both ways. If the stock price rises, the investor makes twice as much profit with utilization of half(50%) borrowed funds as with his own cash only. Similarly, if the stock price falls, the investor loses twice the amount. In slang, this practice is called 'investing on steroids.'

POSITION TAKING
Position Taken with Normal Trading Position Taken with 10 % Margin Trading

Equity

Unutilized Borrowing Capacity

Equity

Borrowings

LEVERAGE: MAGNIFYING EFFECT OF RETURNS

NORMAL TRADING
PARTICULARS Purchase Price of Asset CODE A AMOUNT 1000

MARGIN TRADING
PARTICULARS Purchase Price of Asset CODE A AMOUNT 10000

% Self-financed(100%)
% Borrowed(0%) Change in Value Return(Absolute) <Assumed> Rate of Return(Relative) <Computation> NET VALUE(Asset Value Debt)

B
C=A-B D E=A*D F=E/B*100 F=B+E

1000
20% 200 20% <=200/1000*100> 1200 <Rs.1000+Rs.200>

% Self-financed(10%)
% Borrowed(90%) Change in Value Return(Absolute) <Assumed> Rate of Return(Relative) <Computation> NET VALUE(Asset Value Debt)

B
C=A-B D E=A*D F=E/B* 100 F=B+E

1000
9000 20% 2000 200% <=2000/1000*100> 3000 <Rs.1000+Rs.2000>

It is assumed that the trader has Rs. 1000/- available for investment at the beginning.

MARGINAL OUTCOMES
STOCK PRICE RISES
PARTICULARS Purchase Price of Asset % Self-financed(10%) % Borrowed(90%) Change in Value Return(Absolute) <Assumed> Rate of Return (Relative) <Computation> NET VALUE(Asset Value Debt) CODE A B C=A-B D E=A*D F=E/B* 100 F=B+E AMOUNT 10000 1000 9000 20% 2000 200% <=2000/1000*100> 3000 <Rs.1000+Rs.2000>

STOCK PRICE FALLS

PARTICULARS Purchase Price of Asset CODE A AMOUNT 10000

% Self-financed(10%)
% Borrowed(90%) Change in Value Return(Absolute) <Assumed> Rate of Return (Relative) <Computation> NET VALUE(Asset Value Debt)

B
C=A-B D E=A*D F=E/B *100 F=B+E

1000
9000 (-)20% (-)2000 (-)200% <=(-)2000/1000*100> (-)1000 <Rs.1000-Rs.2000>

We know that all the risks are to be borne by the owner & all the returns to are the right of the owner after paying the fixed costs. Hence, whatever be the effect of the return on the overall investment is to be absorbed solely by the capital investment by the owner.

EXPOSURE: BUYING POWER

For Example, if you were to buy 2000 shares of say Company A, which trades at Rs. 300,

you will need about Rs. 6 lakh. But if you buy a future contract of that company, which comprises 2000 shares, you only need to pay a margin of 15 per cent. So by putting Rs. 90,000, you can get an exposure of Rs. 6 lakh.

The same operation can also be executed through margin trading. Here, the trader will buy

2,000 shares, which are partly funded by the broker, and the rest by the trader.

The percentage of margin funding may range between 50-90 per cent, depending on the

broker and his relationship with the client. The broker, in turn, funds his line of credit from a bank, and keeps the shares in his account with any profit/loss going to the client.

MARGIN TRADING VS. FUTURES TRADING

Most investors buy the futures, but there are times when margin trading makes mores

sense. If a stock is not in the futures list, the client can go for margin funding.

Since futures are generally not available beyond one or two months, if the client has a

longer view, then margin trading is better. Also, some brokers offer lower interest rates on margin trading than the prevalent rates in the futures market.

Generally, when you deposit a margin on a stock purchase, you buy partial equity of the

stock position and owe the balance as debt. In the futures market, a margin acts as a security deposit that protects the exchange from default by the customer or the brokerage house.

THE MARGIN CALL: CHRONOLOGY

Once the trader buys a future or stocks in the margin account, the client gets the profit/loss since his purchase in his account.

In both futures market and margin trading, if the value of the share falls below the purchase price, the broker will make margin calls, if the net value of his investment goes below the margin decided, asking the client to deposit additional margin.

In a normal market, these margin calls are not a problem as clients can deposit the additional amount easily.

When clients are not able to meet the margin requirement, the broker sells the security so that he does not have to bear the risk in case the stock falls further. This typically become a problem when the markets fall far more than expected and traders are not liquid enough to meet the margin calls. And when a lot of traders can't meet margin calls, the situation snowballs.

THE MARGIN CALL

Definition: A broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when your account value depresses to a value calculated by the broker's particular formula. Meaning: You would receive a margin call from a broker if one or more of the securities you had bought (with borrowed money) decreased in value beyond a certain point. You would be forced either to deposit more money in the account or to sell off some of your assets. Once the trader buys a future or stocks in the margin account, the client gets the profit/loss since his purchase in his account. In both futures market and margin trading, if the value of the share falls below the purchase price, the broker will make margin calls, if the net value of his investment goes below the margin decided, asking the client to deposit additional margin. Similarly, it could also happen when the margin requirement is raised, either due to increased volatility or due to legislation. In extreme cases, certain securities may cease to qualify for margin trading; in such a case, the broker will require the trader to either fully fund their position, or to liquidate it. In a normal market, these margin calls are not a problem as clients can deposit the additional amount easily.

When clients are not able to meet the margin requirement, the broker sells the security so that he does not have to bear the risk in case the stock falls further. This typically become a problem when the markets fall far more than expected and traders are not liquid enough to meet the margin calls. And when a lot of traders can't meet margin calls, the situation snowballs.
Margin requirements are reduced for positions that offset each other. For instance spread traders who have offsetting futures contracts do not have to deposit collateral both for their short position & their long position.

THE MARGIN CALL: EXAMPLE

Jane buys a share in a company for $100, using $20 of her own money, and $80 borrowed

from her broker. The net value (share - loan) is $20.

The broker wants a minimum margin requirement of $10. Suppose the share goes down to $85. The net value is now only $5 {net value ($20) -

share loss of ($15)} or {$85(Value of underlying asset)-$80(Value of Debt)}, and Jane will either have to sell the share or repay part of the loan (so that the net value of her position is again above $10).

THE ADVANTAGES
Increased buying power with less money.
More profit with less investment. A trader can burrow up to half of his purchasing price as initial margin. Greatly suitable for day traders, who need to complete more number of trades with higher

volume stocks.

Suitable for experienced traders, having knowledge of stock market trend patterns.

THE RISKS
If the stock goes nowhere, you still have to pay interest on that margin loan.
Add more burdens on traders shoulders in losing trades. Have to payoff interest on margin. Cannot trade all stocks - like OTC stocks, penny stocks, IPOs etc. Your account balance and buying power changes with changes in stock prices. The chance of margin call is always prevailing. You are always obligated to keep a minimum account the maintenance margin. With falling stock prices the traders have much less control. Not advocated for novice traders.

STRATEGIES TO MITIGATE RISK

You can reduce the risk of trading on margin by:

Trading contracts that are lower in volatility. Using advanced trading techniques such as spreads, or positions in which you simultaneously buy and sell contracts in two different commodities or the same commodity for two different months, to reduce the risk. An example of an intramarket spread is buying March crude oil and selling April crude. An example of an intermarket spread is buying crude oil and selling gasoline.

Have ample reserves of cash or marginable securities in your account. Try to keep the margin ratio at 40 percent or less to minimize the chance of a margin call. If you're a beginner, consider using margin to buy stock in large companies that have a relatively stable price and pay a good dividend. Some people buy income stocks that have dividend yields that exceed the margin interest rate, meaning that the stock ends up paying for its own margin loan. Just remember those stop orders. Constantly monitor your stocks. If the market turns against you, the result will be especially painful if you use margin. Have a payback plan for your margin debt. Margin loans against your investments mean that you're paying interest. Your ultimate goal is to make money, and paying interest eats into your profits.

THE END