You must have heard many people saying that stock trading is a ‘gamble’, it’s risky, never get into it, it’s a trap etc etc.But have you ever wondered why are they saying this or ever tried to find out? This is because they must have sometime or the other, lost a huge amount of money in this. They say this only when they have lost money and not when they won. If winning is easy, losing is quite easy too. ‘Margin Trading’ is one of the reasons behind that so-called gamble allegation.
Imagine some people playing teen patti. Seeing some of them win some big amount of money you too decide to place your stakes but unfortunately you fall short of money and ask your friend beside you lend some money. He lends you Rs. 5000 on condition of returning it back to him a day later. With all the hopes you place your bet. You get rich if you get the best set, but what if don’t? Not only you will lose your original amount, you owe your friend Rs. 5000 in spite of your loss. There are chances of splendid profits but at the same time there are chances of magnifying your losses too.
You might have got some idea that this something related to debt. My motive is not to make to afraid of stock trading but it is just to make you aware and to pass on some financial literacy before you get into debt.
WHAT IS MARGIN TRADING?
Margin trading is buying stocks with borrowed money. It is like leveraging where the stocks you buy are kept as collateral. This is kind of loan, your broker provides you to buy stocks. It gives you the ability to buy more than you would have bought with the balance in your cash account. Margin trading facility is only available to online trading customers. The margin account may be part of your standard account opening agreement or may be a complete separate agreement. All new cash accounts are established as cash accounts unless you have submitted a margin application and been approves for margin trading. An initial investment is required for a margin account which varies from broker to broker. This is called minimum margin. You can borrow up to 50% of the purchase price of a stock. This portion is known as initial margin. Currently 50% initial margin is required for taking any position under margin trading and once the position is taken 40% maintenance margin is required.
Since the broker allows you to buy stocks with borrowed money, he also charges interest. The interest rate is generally 18% p.a. It is always beneficial to buy on margin for short-term investments because the longer you keep your investments, the greater the return is needed to offset the costs. Also remember, whenever you sell a stock from your margin account the first right from the proceeds is of your broker towards repayment of the amount you’ve borrowed. Margin account also requires you to maintain a minimum balance as well.
Margin trading increases your buying power in the sense it enables you to buy a little extra with the 50% extra that broker lends you. The buying power of a margin account changes depending on the price movements of the securities.
MARGIN TRADING – THE ADVANTAGES & THE RISKS
Buying on margin not only magnifies your profits it has the capacity to magnify your losses too. This will be better explained through an illustration. Suppose you wish to invest Rs. 30000 in stocks of a growth company whose share price is Rs. 100, but you only have 70% i.e. Rs. 21000 in your cash account. Now your broker lends you the balance 30% which is Rs. 9000 so that you can buy stocks worth Rs. 30000. You purchased 300 shares at Current price of Rs. 100 a share. Now suppose the company you have invested in comes out with better quarterly results and the share price reaches to Rs. 125 and you decide to sell off these share @ Rs.125. After paying Rs. 9000 you borrowed from your broker you still have Rs. 7500 (37500-9000-21000) as your profit which approximately 36% (7500/21000) gain which would have otherwise been just 25% (7500/3000). What if your expectation turns wrong and the share price plunges to Rs. 75? You will have to sell off your shares and with the proceeds you will first have to pay your broker Rs. 9000. This not only puts you in debt but it also decreases your initial investment by Rs. 7500.
Brokerages are same as applicable for normal delivery/square off transaction.
If the value of your securities bought through margin decreases in value beyond the limit specified by your broker or the balance of your margin account falls below the minimum prescribed, the broker asks you to deposit certain some of money before he sells the securities in your account to match the account balance. This call from your broker is known as margin call.
Now you might have understood why some people call stock trading a gamble. It should be clear by now that margin accounts are risky and is not for all investors. If it pumps your gains it can also put it a tough situation if not dealt properly. It is a world where you are more likely to lose lots of money (or make lots of money) when you invest on margin. Buying on margin is for investors who can have a big risk appetite and definitely not for beginners. Do not just blindly jump into stock market otherwise it will be nothing less than a gamble. However if you put some brains with a systematic plan and with a long-term vision, you surely have better chances of winning than you would have at playing teen patti.
Invest wisely and trade cautiously!