Margin trading is a practice in the stock market, where the investor can buy stocks, more than the funds that are available with them. In short, investors can buy stocks they cannot pay for. The broker keeps shares as collateral and lends money for buying shares. A request has to be placed with your broker to open a margin trading account. To start margin trading, one must pay the broker some upfront cash. It is called the minimum margin. Margin trading is a simple way to earn fast money in the stock market.
With the advent of technology, stock market trading has become user-friendly. Even small traders or individuals can deal in stocks with ease.
What is margin trading?
Margin trading is when you transact in stocks with capital that is loaned from the borrower. Margin trading means investing in stocks after going into debt yourself. It works on the idea of leverage. Leveraging is buying more stocks to increase your potential to earn money on your investment. Margin money has risks associated with it. You might earn good profits if you understand the strategy thoroughly. You may also face unexpected losses.
A margin equity requirement is the minimum amount of cash that is necessary to be kept in the margin account. A margin call is triggered if your stock trades below a set limit. Your broker will require you to add more cash to the account at this time. If this requirement is not fulfilled immediately, the broker can sell your shares and you will be liable to pay an outstanding debt to the broker. It is a distress situation for the investor.
To sum it up, your broker funds the margin transaction and the funds are settled later when you square off the position. You will earn a profit if the traded profit is significantly greater than the margin. If this is not the situation while trading, you will incur a loss. To execute margin trades, you must have an insight into a demat account, what it means, the demat account full form and its functioning.
Example of margin trading
Once you open a margin trading account, you are liable to pay the initial margin (IM). A minimum margin (MM) is to be maintained throughout the trading process to shield the volatility.
For example, if the stock of XYZ Ltd. is trading at Rs. 1,000, it falls 5%, IM and MM are 4% and 8% of the total value of shares. The trade-off for this case will be 8%-5%=3%, 3% is less than the minimum margin. This situation concludes that you have to invest more money to maintain the margin else it will be squared off automatically.
Advantages of margin trading
Below are some benefits of margin trading.
- Capitalise on leverage
Margin trading enables you to trade in stocks even if you do not have funds available at a certain point in time. It is one prominent advantage that helps you to capitalise on leverage and make profits.
- Amplified profits
If securities held as collateral increase in value, the borrowing power increases as the collateral basis is increased. Margin trading can amplify profits, as it uses capital held as collateral for trading in stocks.
Other instruments available in the market have a fixed repayment schedule. Margin trading does not have this condition. Also, margin trading only requires a minimum margin to be maintained with the investor.
Disadvantages of margin trading
- Unanticipated losses
The returns on margin trading are amplified. If the price fluctuations do not go as expected, the losses can be significant. It involves borrowing debt even if it is from a broker, there is a liability to pay.
- Minimum balance
A minimum balance requirement is continual in the case of margin trading. The balance is to be deposited and kept with the broker all the time.
- Squaring off
The brokers will have the right to square off the positions in the trade if minimum margins are not maintained. They can do so even if you fail to execute the margin call.
Margin trading can be profitable. But it needs to be carried out with extreme caution and precise knowledge as the chances of losing money can be high.
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