When you invest in the stock market, we’re sure that you look for how you can maximize your profit and earnings with limited investment. Adding leverage is a simple way to increase your potential returns while using limited funds. This means that investors can take a position by paying less than the full amount. For the balance amount, you can use credit provided by your broker so that you only have to pay a percentage of the value of the transaction.
One of the most common ways to do this is via Margin Trading. Margin Trading allows you to enhance your “Buying Power”.
Stock Margin is the amount that you take on credit from your broker to invest in a particular stock/security. The Margin permitted depends on your broker and on the Stock.
Margin trading, refers to borrowing money from your broker and using that money to invest in securities. Put simply, you are taking a loan, buying stocks with the borrowed funds, and then repaying the outstanding amount with applicable interest at a later date.
How does Margin Trading work?
Let’s consider this example. Assume you have Rs 10,000 and wish to buy Stock A worth Rs 20,000, the share price of which is Rs 100. You can invest in Stock A using Rs 10,000 of your own capital, and borrow the remaining Rs 10,000 from your broker. That means you could buy 200 shares of Stock A and own Rs 20,000 worth of that stock. Due to this, your account balance would be = Rs 20,000 (Stock Worth) – Rs 10,000 (Loan from Broker) = Rs 10,000.
If Stock A goes up from Rs 100 to Rs 110, then that means it has increased 10% more than the price at which you invested in the stock. This makes your 200 shares worth Rs 22,000. Due to this, your account balance would be = Rs 22,000 (Stock Worth) – Rs 10,000 (Loan from Broker) = Rs 12,000. This shows how a 10% increase in stock price magnified a 20% increase in your account value.
However, this works the other way too in case of losses.
Now consider, that Stock A drops from Rs 100 to Rs 90. This means that the price at which you purchased Stock A has dropped by -10%. At this point, your 200 shares would be worth Rs 18,000. Due to this, your account balance would be = Rs 18,000 (Stock Worth) – Rs 10,000 (Loan from Broker) = Rs 8,000. Which means that a -10% decline in the price of Stock A magnified to a -20% decrease of your account value.
Advantages of Margin Trading
- Helps investors who would like to invest for the short-term but have a shortage of funds. For example, to take positions during favourable market fluctuations.
- Helps investors to buy larger volumes with smaller amounts, thus amplifying leverage. This can help them profit out of even minor positive market movements.
However, just as Margin Trading magnifies profits, it could also magnify losses. Also, since you have taken credit from your broker, you need to pay interest as agreed upon.
Now, if you invested Rs 1,00,000 in Stock A, using Margin Trading, but the value of the Stock dropped to Rs 85,000, remember, that you will have to incur the loss on investment as well as pay the broker interest on the borrowed funds. Hence trade wisely.
Points to Remember if you want to try Margin Trading
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Be Cautious while Investing:
Margin Trading is meant for responsible investors. Always remember that Margin trading can augment both profits as well as losses. So, plan your investment choices keeping in mind your risk-taking capacity. Also, you still need to meet the Stock Margin requirement for your position, hence always ensure that you have sufficient funds to withstand any momentary move against your position and meet the margin call.
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Use Credit Sensibly:
It is advisable to borrow less than the full amount you are permitted. Especially if you are new to Margin Trading, you should begin with small amounts and increase your investment value gradually.
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Pay back Credit at the Earliest:
Margin is very much like a loan, and you have to pay interest on the borrowed funds. The interest charges are applied to your account until you settle the credit you have borrowed. As interest charges continue to accrue, your debt level increases. As debt increases, the interest charges increase, and so on. Hence, it is recommended to settle the outstanding at the earliest so that you don’t have to pay additional interest.
Remember…
Buying on margin may sound attractive compared to investing using one’s own case, but it’s important to understand that Margin trading is a form of leverage and if the investment doesn’t go as planned, that means losses can be magnified, too.
