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When you open a trading account with a brokerage firm to buy and sell shares, you have two options – a margin account and a cash account. A cash account is relatively simple: you pay for whatever you have bought, and the broker gets a commission from your transactions. A margin trading account is different in that you don’t pay cash upfront for any shares that you buy. Instead, you only deposit a percentage of the transaction; the rest is a loan from the broker.
What is initial margin?
The amount of margin you deposit with the broker before you enter into a transaction is called the initial margin. So why would anyone want to pay this margin to the broker? What advantage does this have over just paying cash and buying shares?
There are some advantages to having a margin account. The biggest is that you can trade in a multiple of this initial margin, in what is known as leverage. This is best illustrated with an example. Let’s say the initial margin is 20 percent. You will be able to trade in Rs 1 crore worth of shares by paying the broker Rs 20 lakh.
This allows for high-volume trades. Now let’s say you decide not to open a margin account, and use only cash for all your transactions. You decide to invest Rs 20,000 and buy 100 shares of XYZ Company at Rs 200 each. After your purchase, prices go up by 10 percent, enabling you to make a profit of Rs 2,000.
Let’s say you decide to invest the same amount of Rs 20,000 with your margin account. If the initial margin is 20 percent, you will be able to buy 400 shares worth Rs 80,000. So if the price goes up by 10 percent, your net gain would be Rs 8,000, instead of Rs 2,000 (as explained previously). On the flip side, if the price fell by 10 percent, your losses would have been just Rs 2,000 if you paid cash, and Rs 8,000 if you relied on margins. So while the returns may be high, the risks are higher too.
In margin trading, the broker is giving you a loan to finance your purchases. There are two ways in which they can do this – they can use their funds or borrow from non-bank financial companies (NBFCs) approved by the Reserve Bank of India (RBI).
What happens if share prices fall? In that case, you may have to deposit an additional margin so that the broker does not incur any losses. This is called a margin call. Let’s use the above example of XYZ Company. Let’s say you bought 400 shares worth Rs 80,000 by paying an initial margin of 20 percent, or Rs 20,000. After that, the share price of XYZ keeps falling. When the value of your investments begins to approach Rs 20,000 – say Rs 25,000 -- you will get a margin call from your broker. You will have to deposit an additional margin to ensure that the sum remains above Rs 20,000. If the margin call is not deposited within the stipulated time, the broker can sell your position without warning, and you will end up with a fair amount of loss.
Margins in stock futures
Margin accounts are not just for stocks; they are extensively used in derivatives like futures and options as well, for shares as well as commodities. Both work on the same principle of initial margin, maintenance margin and leverage, but there are differences between the two. This is something that you should understand while opening a margin account.
|You have ownership of shares while margin trading, so get the benefit of dividends,||No ownership of shares. You make profits from changes in prices|
|Margins are higher, at around 20-25 percent||Margins are lower in the case of futures trading, 10-15 percent|
|There is no mark-to-margin while determining margin calls in case of unfavourable price movements||Margin calls depend on mark-to-market (MTM) – futures are valued daily at market prices, and margin calls will rely on MTM value|
|You have to pay interest on the amount funded by the broker||There is no interest payable in the case of futures trading|
|Positions can be carried forward for an unlimited period||Positions can be carried forward for a maximum of three months|
|You can use margin trading in any stock you want, subject to a few restrictions||Futures trading is available only on certain stocks specified by the stock exchange|
|There is no minimum lot size||The minimum lot size is Rs 5 lakh.|
Margin trading in commodities
Margin accounts are also available for trading in commodity futures and options in commodity exchanges like the Multi-Commodity Exchange (MCX). Margins are generally much lower in commodity trading – they could be as low as 3-5 percent.
This means that traders can take significant positions in commodity futures and options through leverage. As we have pointed about leverage offers considerable scope for profits, but also leaves you open to huge losses. This is particularly true of commodities, whose prices tend to be very volatile compared to stocks.
Types of margins
Margins are calculated in different ways on the cash market segment of stock exchanges. These methods include Value at Risk (VaR), Extreme Loss and Mark to Market margins.
- VaR margin: This is the most common method used. Here, we estimate the probability of loss based on historical price trends and volatility of the stock. It covers the most considerable percentage loss that can be incurred by an investor for shares on a single day with a 99 percent confidence level.
- Extreme Loss margin: This is a margin that covers expected losses in situations that lie outside the coverage of the VaR margin.
- Mark-to-Market margin: MTM is calculated on all open positions at the end of the trading day by comparing transaction price with the closing price of the share for the day.
Is margin trading right for you?
When you open a margin trading account, you should consider if it is suitable for your needs and investment goals. Indeed, there are many advantages to margin trading. The leverage offers considerable scope for profits and losses. You should go into it if you have a high tolerance of risk, the ability to keep your cool in volatile situations, and not go overboard on leverage. Margin trading is not suitable for conservative investors with a low tolerance for risk.
Margin trading is particularly suitable for short-term trading in favourable conditions. Suppose you have reliable information about a company that could affect its share prices. Margin trading will allow you to get higher exposure in that company so that you can make much higher profits. It’s better not to use the margin trading account for long-term speculative trades.
How to open margin account
To do margin trading, you have to open a trading account with Angel Broking. Here are the steps that you need to take:
- Fill the Account Opening Form.
- Submit proof of address and residence like PAN card, Aadhaar card, passport or voter card.
- A company representative will do the verification either in person or on the phone.
- You will also have to sign a `Rights and Obligations’ document.
- After that, you will be given a login ID and password.
- You will now be able to access your account to do margin trading.
Under Securities & Exchange Board of India (SEBI) guidelines, only corporate brokers with a net worth of Rs 3 crore are allowed to offer margin trading facility to traders. With the best-in-class services & technology and also an excellent net-worth Angle Broking is your best choice. So, go ahead and open a margin account with us today!