Margin trading allows day traders to trade for bigger deals than the capacity at a point in time using the borrowed funds from the broker. It is based on collateral loans against margin in cash or Demat securities. These work as per reforms by the Securities and Exchange Board of India (SEBI).
It is the amount you need to pay to the stockbroker to make a trade using a margin account. SEBI has fixed this limit to 50%. You need to pay an upfront margin to your broker before placing a margin trade. Different securities permittes at different levels of margin. Margins are calculated in different ways. Following are the commonly used types of margin:
- VaR margin: It involves the estimation of potential loss based on using historical price trends and the current volatility of the stock. It is the most commonly used method that estimates percentage loss with a 99% confidence level.
- Mark-to-Market margin (MTM): It is based on all open positions at the end of the trading session. It compares the transaction price and closing price of shares in a trading session for estimation.
- Extreme Loss margin: It covers situations of potential losses that the VaR margin does not cover.
Cash Account vs. Margin Trading Account
When a trader opens a Demat and trading account with a stockbroker, they are offered two options, i.e., a margin account and a cash account. With a cash account, you simply pay for whatever security. You have purchased and pay a commission to your broker for these transactions. Whereas with a margin trading account, you do not pay the entire amount of trade. You only deposit a percentage of the trade value, and the remaining is paid by the broker and treated as a loan to you.
Stockbrokers offer free Demat and trading accounts where the account opening fee is zero. A free trading account may not fulfill the requirement of a day trader. Make sure you check the trading platform to be provided.
How Margin Trading Works
Margin trading facility (MTF) is available with SEBI-authorised stockbrokers only. Day traders require a margin trading account with a stockbroker by paying a certain sum of money. The account is subject to minimum balance at all times. The incapability of maintaining the minimum balance may result in squaring off your trading positions by your broker.
The broker places a margin call if the total loan outstanding crosses the security value of your portfolio. You can reduce your loan by depositing funds or providing approved investments. If you are unable to meet a margin call, as the last option, your broker may square off your open positions or sell collateralized Demat securities or investments.
Margin Trading in Commodities
You can trade in commodities futures and options using your margin accounts on commodity exchanges, i.e., the Multi-Commodity Exchange (MCX). Commodity margin trading requires a lower margin than other segments. As per SEBI’s new margin rule, a gross margin benefit of 75% will be allowed on the initial margin. However, it is allowed for eligible offsetting positions only.
You are trading in commodities that are highly volatile. Therefore, do not ever forget that the leveraged positions carry considerable scope for profits. But it leaves you open to potentially huge losses.
Margin Trading in Shares
When you trade shares on margin, there is no minimum lot size to trade, and you can trade any stock of your choice. You are liable to pay interest on the marginal loan from the broker. You can carry forward the position for an unlimited time.
Margin trading in Futures
To trade futures, there is a minimum lot requirement of up to 5 lakhs that may vary from broker to broker. Margin calls rely on MTM value. You need not pay interest for futures trading. If you want to carry forward the positions, it can be done for a maximum of three months. Futures margin trading is limited to certain stocks based on stock exchange norms.
Strategies to avoid losses
A Margin trading involves lofty risk, therefore, inappropriate for many situations. Following a disciplined strategy, it can prove an effective tool for trading if you know the right situations to use it.
- Use margin trading for appropriate assets only. You need to be selective in what you buy on margin, as where a wrong decision can cost you hugely. Hot stock can be a risky choice for margin trading.
- Limit margin trades to short periods to avoid interest on your borrowed funds.
- Do not reach a level of margin calls. It may result in liquidating your market positions.
- Be sure about when to exit.
- Avoid utilizing the entire leverage limit.
Benefits of Margin Trading
- After the reformed rules, if collateralised Demat stocks’ value increases, you can enjoy an increased margin limit. Utilising the increased value, you can take new positions with your margin account.
- You can receive dividend income on collateral stocks. It will be credited to your bank account with your trading account.
Thus, you can utilize margin trading with wise decisions.