Written by If you are about to open a demat account, you need to understand the two ways in which you can take a position in the stock market. First, you can take a position by using your own funds. Second, you can also take a position by using a mix of your own funds and borrowed funds. When you borrow funds from a broker to take a position in the market, it is called margin trade.
Before using margin to trade, you need to check whether your broker provides a margin trading facility (MTF) or not. Then, you should check how much MTF interest rate he charges.
Example of using margin trade in the stock market
Suppose you have ₹20,000 in your trading account and you want to buy a stock called X, which is trading at ₹1,000. With your own funds, you can buy only 20 stocks of X. However, you want to buy 60 stocks.
You check with your broker and he tells you that he provides a leverage of 1:3. This means if you have ₹1 in your trading account, you can borrow ₹2 from your broker. As you have ₹20,000 in your account, you can borrow up to ₹40,000 from your broker.
Hence, you borrow ₹40,000 from your broker and buy 60 stocks of X. Let us say that X’s price rises to ₹1,100 and you decide to sell it. Your sales proceeds are ₹66,000 (60*1,100), which means you have earned a profit of ₹6,000 (66,000-60,000). However, your own capital is only ₹20,000 and not ₹60,000 (because you had borrowed ₹40,000).
Therefore, you have earned a profit of 30% (6,000/20,000). In other words, you have amplified your profits by using stock margin. That said, just as margin trading amplifies your profits, it can also multiply your losses. Hence, you should be careful while using this strategy.
Things to keep in mind while using margin trading
- MTF interest rate: You must ask your broker how much interest rate he charges on his margin facility. In the example above, your real profit will be less than ₹6,000 because you will have to pay interest to your broker. Bear in mind that you have to pay interest even when you incur losses by using margin.
- Monitor your margin levels: When you take a position using margin, you have to maintain your margin levels at all times. If your position does not move in the desired direction, your margin may dip lower than the minimum required level. In such a situation, your broker can issue a margin call, thereby telling you to deposit more funds. If you fail to do so, he may liquidate your position.
- Calculate maximum bearable loss: You need to realise that a leveraged position is riskier than a non-leveraged position because it can amplify your losses. Hence, while using stock margin, you must estimate your maximum bearable loss. In other words, how much loss you can bear without losing your sleep. Only after calculating it, you should use margin. At times, traders use margin by only thinking of maximum possible gains and not maximum possible losses. As a result, when their losses get amplified, they get stressed out and are not able to deal with the situation.
Conclusion
There is no denying that margin trading helps you capitalise on opportunities and amplify your profits. But, you need to do a lot of homework before using margin. First, you need to study the stock market thoroughly, which will help you gauge the direction of prices. Second, you should select the right broker who does not charge a high MTF interest rate. Third, you should calculate the maximum loss that you can bear. After taking all these steps, if you feel comfortable with the idea of margin trading, you should initiate such trades.
