Margin trading, as the name sounds, is actually purchasing stock by paying just a margin of the actual price of stock when you can’t afford it.
In other words, it is a facility where Investors are allowed to buy more securities than what he can afford with the available money at that time. Lets understand this is detail.
What is margin trading?
Suppose you want to buy a stock but you can’t afford it. You can still buy it by paying just a portion of it and the rest will be funded by your broker.
The portion of amount that you have paid is termed as margin, and for the rest amount that you have lend from the broker, you have to pay some interest on it.
If your broker gives you 10 times margin, this means that you can buy 10 times more stock that what you could buy without margin with same amount.
The total profit earned on your stock, if the stock price goes up, is totally of yours and none would be shared with your broker.
Same as if loss occurs, it would totally bear by you. But why broker lends you money when they not take the profit share. Lets see it in the next section.
How margin trading works?
In order to avail the facility of margin trading, you are first required to place a request with your broker to open a Margin Trading Facility (MTF) account. This requires you to pay a certain amount of money upfront to the broker in cash, which is called the minimum margin. This minimum margin should be maintained in the account, failing this your account could be closed.
Once your account is opened, your are ready for trading. For any trading, you only need to Invest only a portion of the total Investment value called margin and the rest will be handled by your broker. The margin is decided by the broker after the opening of account.
Please note, this money provided by the broker is a type of loan and you have to pay a small amount of Interest on it.
By adding your margin amount and the broker’s amount, you will be able to buy the shares of a a big company and can make huge profit on it which totally belong to you.
Take an example :-
Suppose you want to buy share worth 1000$, but you haven’t the entire amount. You can still Invest in that share with margin trading.
Let the margin decided by your broker is 20%. Then you only need to pay 200$( 20% of 1000%) only and the rest amount of 800$ is financed by your broker.
You will have to pay small amount of Interest on 800$ funded by your broker. The profit earned on your Investment of 1000$ is totally belongs to you and none of it is shared by your brokers.
Most of the broker provides you margin only for Intraday trading which refers to buying and selling of stocks on the same day before the market closes. Only few provides are which provide margin for position or swing trading. There is no scheme for long term leverage or margin trading.
Why broker provides margin or leverage?
When the profit is not shared by your broker, then why he fund your Investments. The answer lies in the business model of margin trading which ends broker making profit either your Investment rise or fall.
The very first income of brokers are their brokerage. For any sell or buy of the stocks, brokers get their brokerage.
The brokerage depends on the value of the share purchased through the broker. Take example, if you buy a share of 100 bucks through broker without any margin and let he charged a brokerage of 1%. Then his total earning as a brokerage is 1 buck. Now let he gives a margin of 10% of the same Investment. The you will be able to buy the share of worth 1000 buck with same amount of 100 buck. Then in this case the brokerage earned by the broker would be 10 bucks. That’s it.
Also the amount lend by your broker is Interest chargeable, which makes him earn money from it. Even though you get a loss in your Investment which cause even broker’s money to lose, then your minimum margin paid initially to open the account will be used by the broker to makeup his loss. In that case you will be asked to add more money again as a minimum margin to restart Investment.
Advantages of margin trading
Clearly, it increases the Investing capability of an Investor. You can buy margin times more stocks with the same amount of money.
For example, if you can buy 1 stock with 100$ without margin, then with 10% margin you can now buy 10 stocks with same 100$ amount.
It is a way of making huge profit in very short time. Since you are able to buy more stocks, you will earn more profit if stock price goes up.
Margin trading is apt for those investors looking at en-cashing on the price fluctuations over a short-term but do not enough cash in hand.
If you buy 50 shares in a company at $50 each through margin trading at morning, you’ll have spent $2,500 on the shares. If those shares increase in value by 5% at evening, you will make $125 if you sell those shares. So just in a span of 12hrs you make a huge profit.
Disadvantages of margin trading
As your profit depends on the stock value on which you have Invested, you will end up with big loss if the stock price fluctuate downwards. You may lose more than what you spend as you also have to give the the Interest on the borrowed money from broker.
Also you are supposed to maintain a minimum balance in your margin trade account at all times. If your balance falls below the minimum balance, then your broker would ask you to maintain sufficient balance. If you are unable to maintain the minimum balance, then you would be forced to sell some or all the assets to maintain the minimum balance.
Conclusion
In conclusion, margin trading is a powerful financial tool that offers both opportunities and risks to investors and traders in various financial markets. It allows participants to amplify their potential returns by leveraging borrowed funds to increase their trading positions. However, this increased leverage also magnifies the potential losses, which can lead to significant financial instability and even the loss of the entire invested capital.
Margin trading demands a thorough understanding of market dynamics, risk management strategies, and a disciplined approach. While it can yield impressive gains in favorable market conditions, it requires careful monitoring and swift decision-making to prevent losses from spiraling out of control. Novice traders should exercise caution and ideally gain experience with less risky investment strategies before venturing into margin trading.
Regulatory frameworks and risk management tools have been put in place by financial institutions to mitigate the adverse effects of excessive leveraging and to protect market stability. It’s crucial for traders to adhere to these guidelines and to educate themselves extensively before engaging in margin trading.
Ultimately, margin trading is a complex practice that can offer potential rewards for those who have the knowledge, experience, and risk appetite to navigate its challenges. It’s not suitable for everyone and should only be pursued after careful consideration of one’s financial goals, risk tolerance, and understanding of the associated complexities.