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What is Margin Trading?

5paisa Research Team Date: 13 Jul, 2023 12:26 PM IST

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Introduction

Margin trading is the process of borrowing capital to increase the size of a trading position. Traders use margin to leverage their accounts and trade with more money than what's in their accounts. Margin allows traders to magnify their returns if they're right and lose more if they're wrong.

Margin trading can be used as a hedge against losses. Still, it also carries additional risks, such as increased volatility and the possibility that you'll lose more than what you have invested.

What is Margin Trading?

Margin trading refers to using borrowed funds from a broker to trade a financial asset, which forms the collateral for the loan from the broker. Since margin trading requires maintaining a minimum account balance on your brokerage account, it is considered riskier than traditional trading.

Since profits or losses from margin trading are based on the total value of the position, margin allows investors to leverage their accounts to make a greater profit.

While many types of assets can be traded on margin, this is most commonly associated with trading stocks. In stock trading, margin trading allows traders to open positions using leverage from peer-to-peer margin funding providers.

Professional traders often use margin trading because it allows you to make greater profits than trading through a standard cash account. However, it can also result in greater losses if things go against you.

Significance of Margin Trading

Investors use margin accounts to leverage their purchases and increase the potential return on a given investment. If they are correct in their predictions and the value of their assets increases, they earn the profits on their capital and the earnings on the borrowed money. On the other hand, if they are wrong and the value of their investments declines, they lose their capital and their profits on borrowed money (which may end up being more than all of their initial capital). Their losses are then magnified by any fees and interest charges assessed by the lender.

In addition to using margin accounts for investing purposes, individuals can use them for day trading. Day traders attempt to make quick profits by buying and selling stocks within a single trading day. In India, margin trading is available only for securities. The Securities and Exchange Board of India (SEBI) has allowed investors to trade on the stock exchanges using margins in their Demat accounts. The most crucial aspect of SEBI's decision to allow margin trading is that it will help investors earn more from their investments when the market is highly volatile.

The two types of margins used for trading are day-trading and overnight margins. Day-trading margins allow investors to buy securities on margin with a 50% cash down payment, which comes from their brokerage account. Overnight margins enable investors to purchase securities with less than 50% down payment, allowing them to leverage their assets.

How is Margin Calculated?

Margin, or leverage, is the amount of money brokers lend you. The margin % is based on the current market value of your portfolio and serves as a guarantee that you can make good on your trades.
The margin limit is the amount of money brokers allow you to borrow. The margin limit is a percentage of the total value of securities in your account. For example, if your account has ₹1 lakh worth of securities, and your broker allows a 50% margin limit, he will lend ₹50,000 to buy securities. However, your broker may offer a higher or lower margin percentage depending on his assessment of the risk involved in lending.

Margin is calculated by subtracting the total cost of securities by the total market value of securities. Margin % is then applied to the result to determine the yield on cost.

How Does Margin Trading Work?

When you buy securities on margin, you borrow money from your brokerage firm to pay for all or part of the purchase price of securities and agree to repay the loan over time. The amount you borrow depends on how much margin is available in your account, which varies depending on what type of asset you're buying using borrowed funds.

The amount of margin you are allowed depends on your broker and the specific instrument you wish to trade. For example, if you want to trade shares, your broker may allow you to trade 10% of the total value of a particular stock. You then have to provide the remaining 90% that makes up the full value of the stock from your funds. If you want to trade forex, some brokers will allow you to trade 50% or even 100% of a currency pair with margin.

The brokerage house owns these stocks and gives you a loan based on their market price until your loan tenure ends. You can place orders and make profits from this loan amount, which will be settled when the loan tenure ends or close all open positions (whichever comes first).

The profit and loss would be settled at the end of each trading day, not on a contract note. The broker charges a brokerage fee for allowing such a borrowing facility. Margin trading is usually done by professional traders who have years of experience in financial markets and manage risks.

Wrapping Up

Margin trading became popular in India when the current market was opened up to foreign investors. Although the word margin itself is not new, the trading system is commonly followed in the stock market. With the help of this system, one can register multiple trades with a single transaction, which leads to increased profits. Margin trading is also known as leverage entering as it uses neither a borrower nor a lending scheme for excess funds traded in other to earn profits.

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