Margin trading basics
In financial terms, margin refers to the money borrowed from your broker to purchase an investment, i.e., stocks, currency, or commodities, etc. It is the difference between the total value of your investment and the loan you have borrowed from your broker to purchase that investment. In this process, an investor only pays a certain percentage of the investment’s value and the broker covers the rest, and the investments act as collateral. To simplify this concept, assume that you have an initial margin requirement of 40% for your margin account and you are interested in purchasing security worth $2000. In this case, your margin would be $800 (40% x $2000), and the rest can be borrowed from your broker. This whole act of purchasing securities/investments on borrowed money from your broker and those securities/investments acting as collateral is called margin trading.
Moreover, leverage, exposure, and margin go hand in hand in trading. Exposure refers to the total amount of money you have invested in a specific asset and how much you can potentially lose on that particular investment. Leverage is the use of borrowed capital to increase an investor’s position in a trade. It helps an investor to take help from an outside source, which is the broker, in this case, to increase his overall exposure on a specific trade. Leverage is usually given in ratio form such as 1:500 which means that for every $1 of an investor’s money, the investors receives $500 to trade with.
Pros and Cons of Margin Trading
However, the concept of margin trading and leverage may seem attractive at first, but it is vital to know the pros and cons of margin trading. Firstly, the primary advantage of margin trading is greater buying power. If you have faith in your trading skills and analysis, then margin trading acts as a stimulus for you. To understand this concept, let’s say you believe that Tesla’s stock may go down in the future and you want to go short on the stock. Still, you don’t have enough money to take a bigger position, but with margin, you can double or triple (depending on your margin percentage) your short position on Tesla. Another advantage of margin trading is portfolio diversification. With the help of margin, a retail trader can invest in different securities and diversify his portfolio. For example, an investor has $500 to invest; without margin, he could only buy few shares of few securities, but with margin, he could expand his portfolio and invest in different securities.
The major disadvantage of margin trading is increased risk. As you take a bigger position, your exposure automatically increases, which results in more openness to risk. However, this risk can be minimized with proper risk management techniques such as a consistent risk to reward ratio in each trade. The second disadvantage that should not be ignored is the margin calls by your broker. Margin call, in simple words, means that your broker is warning that your equity is slowing reaching a point where it cannot support the minimum margin requirements, and in the end, you will be left with a small percentage of your initial investment.
You can calculate margin yourself before entering any trade by a simple formula, i.e., margin requirement = current price x unites trader x margin. Let’s assume you want to buy 1,000 shares of Facebook with a current price of $300 and your broker requires a 4% margin, then the required margin would be (300 x 1000 x 4% = $12,000).
There are various scenarios in the investment world that offer margins. The first thing to consider is that delivery trading is different from margin trading. In equity delivery trading, you hold the stocks in your Demat account for some time and then sell them when a suitable opportunity arises. However, in equity intraday, margin allows an investor to borrow money from his broker and take on a bigger position on his trade. The case is similar in equity future and options, both of which are part of derivatives. Through margin, an investor must deposit his investments or assets in the account as collateral before selling, and the Federal reserve board sets these margin requirements. The general margin requirements are 5% to 10%. The same concept is carried on in the forex, where you can use margin to trade currency futures or currency options. Many investors, with the help of margin, increase their exposure even in commodities. Their commodities are held as collateral as they have used the option of margin trading.
Lastly, there are both good and bad in margin trading, and it is up to you as an investor whether to opt for this option or not. If you believe that you can handle the stress of margin trading and margin calls, then you must go for this and take a bigger trade position for a bigger return, but if you are new as an investor, you must stick to the basics of investing before trying out margin trading.
Find below the margin calculators for all the stockbrokers in India.