Last Updated on October 30, 2023 by BFSLTeam BFSLTeam
If you are new to the stock markets or interested in making investments in shares and other securities, you must familiarise yourself with the idea of margin and margin trading. The concept is fairly simple: you need to provide a certain amount as a security deposit or good faith payment to do the trading. It is to be made by the buyers as well as the sellers and is an expression of seriousness on part of the both.
There are several types of margins that you need to know if you want to excel in the financial market. Read on to know more about the concept of margin, different types of margins and its risks and rewards.
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What is Margin Trading?
Margin trading is an investment technique that lets you buy stocks and other securities by availing a loan from your broker. This borrowed amount allows you to control larger positions with a smaller investment, called the margin.
Margin trading, practically, amplifies your purchasing power, gives you the potential to earn higher profits but also exposes you to higher risks. In case the value of your securities fall below a limit, the lender will make a margin call and demand additional funds. You can provide the additional funds to mitigate the margin call by several ways, like repaying from your own cash resources, sell some shares that are used as collateral, or provide additional security.
In case you could not meet the margin call, your lender may sell some or all of your collateral securities to reach the agreed amount. You would need a margin account to initiate margin trading.
If the borrower does not meet the margin call within the specified time, the lender may sell sufficient shares and apply the sale proceeds in repayment of the loan so that it is reduced to the agreed amount.
Read More: What is Margin Trading Facility – A Detailed Guide
Types of Margin Accounts
There are primarily two types of margin accounts offered by brokers in India: Cash accounts with margin and Margin accounts.
- Cash accounts with margin: This account lets you borrow a limited amount against your existing funds to buy securities. The broker, who gives you the loan, provides you with a specific margin limit based on the value of your holdings. This type of margin account is best for conservative traders who do not want to take an excessive risk.
- Margin account: A margin account is a brokerage account in which your broker will provide you a loan to purchase securities. The broker will keep your securities as collateral against the borrowed amount. In this case, you can buy securities worth more than the total balance in your account.
Different Types of Margins
Here are the different types of margins that you should know before getting involved in margin trading.
- Initial Margin: A minimum amount that you must have in your margin account to initiate a trade is called the initial margin. This margin acts as collateral against potential losses on your borrowed funds. The Securities and Exchange Board of India (SEBI) sets specific guidelines for initial margins on different securities to ensure responsible trading practices.
- Maintenance Margin: Once you initiate a trade with the initial margin,, you are required to maintain a minimum level of equity in your account. It is called the maintenance margin. This margin is usually a percentage of the total value of the position.
- Variation Margin: This type of margin is based on the daily profit or loss on your open positions. It provided protection by ensuring that the exposures due to market movement between margin calls will be limited. At the end of each trading day, the gains or losses are added or deducted from your account balance, respectively. This process continues daily until you close your position.
- Gross Exposure Margin: The gross exposure margin is the total value of all your open positions in the market. This type of margin helps control the overall risk in your portfolio by limiting the total exposure.
- Span Margin: The span margin is a risk-based margin calculation method used for futures and options contracts. It considers various factors like volatility, contract value, and market conditions to determine the margin requirement for each position.
- Special Margin: In certain situations, the stock exchanges may impose special margin requirements on specific securities due to their high volatility or market conditions. Special margins are imposed to safeguard market stability and protect investors from excessive risk.
- Volatility Margin: Volatility margin takes into account the price volatility of a security or market. Securities with higher volatility require higher margins to mitigate the risk associated with sharp price swings.
- Ad-hoc Margin: Ad-hoc margins are additional margin requirements imposed by the stock exchange or the broker in extraordinary circumstances. These margins are not standard and are implemented to address specific risks or situations that may arise unexpectedly.
The Risks and Rewards of Margin Trading
While margin trading offers the potential for higher profits, it also comes with increased risks that every investor should consider:
- Leverage Risk: Since you are borrowing money to invest, your potential losses are magnified as well. A small adverse price movement could lead to significant losses.
- Margin Call Risk: If the value of your investment falls below the maintenance margin level, you’ll receive a margin call, requiring you to add funds to your account. Failure to do so may result in the broker liquidating your positions to recover the loaned amount.
- Interest Costs: Borrowing money from your broker incurs interest charges, which can eat into your profits, especially if you hold positions for an extended period.
On the other hand, margin trading can be rewarding if done responsibly. It can amplify your gains when you make profitable trades and enable you to take advantage of short-term trading opportunities.
Read More: The Pros and Cons of Margin Trading
How to Use Margin Trading Wisely
To ensure you use margin trading responsibly and to your advantage, consider the following tips:
- Risk Management: Have a clear risk management strategy in place. Only use margin for a portion of your overall investment and avoid risking more than you can afford to lose.
- Stay Informed: Keep yourself updated with market trends, company news, and other relevant information that can impact your investments. Being informed will help you make better decisions while trading on margin.
- Diversify Your Portfolio: Don’t rely solely on margin trading for your investment portfolio. Diversify across different asset classes to spread risk.
- Avoid Emotional Trading: Margin trading can evoke strong emotions, particularly when the market experiences high volatility. To maintain control over your investments, it’s crucial to adhere to your trading plan and refrain from making hasty and impulsive choices.
Also Read: Top Tips for Successful Margin Trading
Conclusion
Margin trading is the new era of investment and can be a game-changer for any investor if utilised with experience, patience and knowledge. By staying informed about the different types of margins, you limit the scope for risks and increase the potential for rewards.
Always consult with a qualified financial advisor or broker to understand the specific margin requirements and rules. Always remember that margin trading is an avenue for you to earn a higher profit but also the potential for severe losses.
