August 21, 2024

Margin Trading: Key Precautions to Can Take

margin trading

margin trading

While using margin trading, if a share’s prices falls drastically, your broker may issue a margin call by telling you to deposit more funds.

If you are about to open a demat account and start trading in the stock market, you should know that the market is often extremely unpredictable. You may have money in your trading account, but the market may not provide you with a trading opportunity.

On the other hand, you may find a great opportunity to trade when you do not have sufficient money in your account. You can use margin trading to buy shares when you do not have sufficient money in your trading account.

What Is Margin Money And What Is A Margin Trading Facility?

If you do not have sufficient funds to buy shares, you can use margin trading to purchase the shares. Understanding what is margin trading facility allows you to borrow from your broker to buy more shares than your own funds permit. But, to use this facility, you need to follow the due process.

You need to submit a request to your broker to start a margin trading facility (MTF) account. Your broker will tell you that you need to have a minimum balance in your margin account.

Before you start this facility to trade, you will be required to deposit a specific percentage of the transaction’s value (also known as “margin money”), while your broker will fund the remaining.

Bear in mind that your broker gives you a loan to buy securities in this case. Hence, he will charge you interest on the funds he will provide. For the loan the broker provides, either your minimum margin or the shares you buy are used as collateral.

To understand it better, let us take an example. Suppose you have ₹1,000 in your trading account. Your broker offers a margin of 3:1, which means you can buy shares worth ₹3,000 by using ₹1,000 of your own and borrowing ₹2,000 from your broker.

Using this facility, you buy 150 shares priced at ₹20 each. If the stock price increases to ₹25, your investment is worth ₹3,750 (25*150), which means you have earned 75% profit (750/1000). Hence, the leverage has helped magnify your profit.

However, suppose the stock price falls to ₹15, which means your investment is worth ₹2,250. Consequently, you have lost ₹750 on an investment of ₹1,000, resulting in a 75% loss, which is huge.

While using margin trading, if a share’s price falls drastically, your broker may issue a margin call by telling you to deposit more funds. If you are unable to do so, your broker can sell your position.

Hence, if margin trading has advantages, it has risks too. Now, let us discuss how to take precautions.

Precautions To Take While Using A Margin Trading Facility (Mtf)

1. Invest Carefully

Margin trading can magnify your profits and losses. Hence, you should use MTF only if you have adequate cash to deal with a situation when a stock’s price does not move in the desired direction.

2. Use MTF Only for a Short Duration

Keep in mind that using MTF is akin to taking a loan. Hence, you should use this facility for a short duration. The shorter the duration, the lower the interest you will have to pay. Therefore, you should settle the margin as soon as you can so that you do not have to pay excessive interest on it.

3. Do Not Borrow the Full Allowed Limit

To be on the safer side, you should borrow less than the full allowed limit on an MTF. Remember that margin trading is a leveraged trading strategy and hence it is advisable to be conservative. If you borrow the full allowed limit, you are borrowing the most you can.

Hence, you will be under great pressure to pay a high interest and you will be extremely worried if the stock’s price does not move in the desired direction. 

Conclusion

It is not tough to understand concepts like margin money and margin trading facility. However, you must take precautions while using the MTF because it is a highly risky strategy for the reasons explained above.

Frequently Asked Questions

1. What is margin trading in the share market?
Margin trading allows investors to borrow money from a broker to buy more shares than they can afford with their own funds. It involves leveraging, where you only need to deposit a margin (a portion of the total investment), while the broker lends you the rest.

2. How does margin trading work?
In margin trading, brokers lend investors a certain percentage of the share value to buy stocks. The investor pays interest on the borrowed amount and must maintain a minimum balance, called a margin, in their account. If the stock value drops, the investor may face a “margin call,” where they need to deposit additional funds.

3. What are the benefits of margin trading?
Margin trading allows you to amplify potential gains, as you can invest in more stocks than your available cash. It also gives investors more flexibility and the ability to capitalize on short-term market opportunities.

4. What are the risks associated with margin trading?
The biggest risk is magnified losses. If the value of the stock falls, you may not only lose your investment but also owe the broker money. There’s also the risk of margin calls, where the broker demands additional funds or liquidates your stocks if you fail to meet the minimum margin requirements.

5. What precautions should you take when using margin trading?

  • Understand the risks: Only trade on margin if you’re fully aware of the potential for amplified losses.
  • Start small: Use margin trading cautiously and invest small amounts initially to minimize risk.
  • Monitor your portfolio closely: Market fluctuations can quickly impact your position, so stay updated and be prepared to act if necessary.
  • Maintain a buffer: Keep extra funds in your account to avoid margin calls.
  • Set stop-loss orders: These can help limit your losses if the stock price moves against your expectations.