Margin Trading

Suppose you want to buy shares of XYZ Company. You hope that in future the stock price will go up and you will make good profit. You have 50 Rs. with you. Stock is trading at 10 Rs. So with the money you have you can buy 5 share. Here your expectations are high on this stock. Hence you want to buy more than 5. But you don’t have the money. In this case you can take a loan from your broker. Suppose you buy 10 shares (50 Rs. borrowed from broker).

This mechanism of buying stock by borrowing money from broker is known as Margin Trading. It’s about borrowing money to buy more stock than you could own with your money. Investors generally indulge in margin trading because it provides opportunity to ramp up their profit by leveraging.

But margin trading is a risky proposition. As its increases returns so downside risk is also dramatically increases. To understand this mechanism lets take an example which we took on the first paragraph. Now suppose that as an investor you have bought shares worth 100 Rs. by borrowing 50 Rs. from your broker.

(1)Price at later stage	(2)Amount Paid back to broker	(3)Value of your Investment (1-2)	(4) Profit/ Loss ((3)-50)	(5) Profit/ Loss in % terms
140	50	90	40	80%
130	50	80	30	60%
120	50	70	20	40%
110	50	60	10	20%
90	50	40	-10	-20%
80	50	30	-20	-40%
70	50	20	-30	-60%
60	50	10	-40	-80%

So from above table we can say that for a 40% increase in price of stock has resulted in 80% profit !!!!! Isn’t it looks great but read a bit further for 40% decrease in price your loss is 80%..... Shocking ????

Mathematically we can put this formula for calculating profit/loss as follows:

Profit/Loss= Change in price(% terms)/(your own money in total investment in decimal terms)

Example: you bought 50,000 worth share by borrowing 20,000. Your own money is 30,000.

So your own money in total investment in decimal terms= 30000/50000= 0.6

Now lets take two cases, in first price goes up by 20% second price falls by 30%.

Profit in first case= 20/.6= 33.334 %

Loss in second case= 30/.6= 50%

Why this happens? Simple, broker doesn’t participate in your profit or loss. A broker only gets some fee for providing you this facility; you need a margin account to avail this facility apart from usual cash account. For the money you have borrowed from him, he takes your shares as collateral.

Margin accounts can be very risky. They are not suitable for everyone. Things one should keep in mind before going for margin trading:

* Money one can loose can be more than what he has invested;

* Your broker may ask you to deposit more cash or security in your account on short notice to cover market losses (Known as margin call);

* You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities.

One should check his risk appetite before venturing into margin trading.

Regulation in India (taken from SEBI/MRD/SE/SU/Cir-15/04)

In US Federal Reserve Board and individual self-regulating organizations, such as the NASD or NYSE regulates and issues guidelines for margin trading. In India SEBI is regulatory body for this.

On March 19, 2004 SEBI through its circular clarified regulations for margin trading:

Corporate brokers with net worth of at least Rs 3 crore are eligible for providing Margin trading facility to their clients subject to their entering into an agreement to that effect. Before providing margin trading facility to a client, the member and the client have been mandated to sign an agreement for this purpose in the format specified by SEBI. It has also been specified that the client shall not avail the facility from more than one broker at any time.

The facility of margin trading is available for Group 1 securities and those securities which are offered in the initial public offers and meet the conditions for inclusion in the derivatives segment of the stock exchanges.

For providing the margin trading facility, a broker may use his own funds or borrow from scheduled commercial banks or NBFCs regulated by the RBI. A broker is not allowed to borrow funds from any other source.

The "total exposure" of the broker towards the margin trading facility should not exceed the borrowed funds and 50 per cent of his "net worth". While providing the margin trading facility, the broker has to ensure that the exposure to a single client does not exceed 10 per cent of the "total exposure" of the broker.

Initial margin has been prescribed as 50% and the maintenance margin has been prescribed as 40%.

The arbitration mechanism of the exchange would not be available for settlement of disputes, if any, between the client and broker, arising out of the margin trading facility. However, all transactions done on the exchange, whether normal or through margin trading facility, shall be covered under the arbitration mechanism of the exchange.

External reference: http://web.sebi.gov.in/cis/circulars/2004/cirsmd152004.html