Margin trading, as the name sounds, is actually purchasing stock by paying just a margin of the actual price of the stock when you can’t afford it.
In other words, it is a facility where Investors are allowed to buy more securities than what they can afford with the available money at that time. Let us 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 the amount that you have paid is termed as margin, and for the rest amount that you have to lend from the broker, you have to pay some interest on it.
If your broker gives you 10 times the margin, this means that you can buy 10 times more stock than what you could buy without a margin with the same amount.
The total profit earned on your stock, if the stock price goes up, is a total of yours and none would be shared with your broker.
Same as if a loss occurs, it would totally bear by you. But why broker lends you money when they do not take the profit share? Lets see it in the next section.
How does margin trading work?
In order to avail of 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 up front 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, you 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 the 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 big company and can make a huge profit on it which totally belongs to you.
Take an example:-
Suppose you want to buy a 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 a small amount of Interest on 800$ funded by your broker. The profit earned on your Investment of 1000$ totally belongs to you and none of it is shared by your brokers.
Most of broker provides you margin only for Intraday trading which refers to buying and selling stocks on the same day before the market closes. Only a few providers are which provide a 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 does he funds your Investments. The answer lies in the business model of margin trading which ends broker making a profit either your Investment rise or falls.
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 an example, if you buy a share of 100 bucks through a broker without any margin and let he charge a brokerage of 1%. Then his total earnings 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 bucks with the same amount of 100 bucks. Then in this case the brokerage earned by the broker would be 10 bucks. That’s it.
Also, the amount lent by your broker is Interest chargeable, which makes him earn money from it. Even though you get a loss in your Investment which causes even the broker’s money to lose, then your minimum margin paid initially to open the account will be used by the broker to make up 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 a 10% margin you can now buy 10 stocks with the same 100$ amount.
It is a way of making huge profits in a very short time. Since you are able to buy more stocks, you will earn more profit if the 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 have enough cash in hand.
If you buy 50 shares in a company at $50 each through margin trading at the morning, you’ll have spent $2,500 on the shares. If those shares increase in value by 5% at the 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 fluctuates downwards. You may lose more than what you spend as you also have to give the Interest on the borrowed money from the 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.Post n