Margin funding is borrowing money from a brokerage to trade stocks or other securities. Stocks held in your account are used as collateral for the loan, and the brokerage charges interest for the duration of the loan.
In the investment world, buying stocks using borrowed money is known as a trading ‘on margin.’ When a stock’s price rises, margin trading allows investors to use leverage to increase their gains. However, when share prices fall, losses mount much more quickly.
How does Margin Funding & Trading Work?
Before margin trading funding, you should understand the account requirements, how margin works, and the characteristics and risks.
- You must open a Demat and a trading account with a stockbroker to open a margin account.
- Next, you must deposit or transfer money in your trading account (in your equity segment).
- Check with your broker the list of eligible securities for margin trading. Not all securities traded on an exchange are offered on margin trading.
- Securities available for margin trading require a different initial margin, i.e., the amount the trader must bring in or deposit before seeking a loan on the balance of the security value. For example, if a security market value is Rs 500/- per share, and margin funding or loan by the broker on this security is available up to 60%, then the initial 40% of the security market value would need to be brought in by the trader. This 40% wouldn’t be funded or loaned by the stockbroker.
- The stockbroker will charge interest on the borrowed funds as long as the loan is outstanding.
People commonly borrow on margin to purchase stocks, although other securities, including ETFs, mutual funds, bonds, and options, can also be purchased. You can also use a margin account to short-sell stocks.
Example: Margin Funding & Trading
Let’s explore an example where you buy Rs 20,000 worth of shares by putting up Rs 10,000, your own money, and borrowing Rs 10,000 on margin.
Suppose the share price increases 50% in value to Rs 30,000, and you sell your shares. The Rs 30,000 sale will pay back the Rs 10,000 borrowed, leaving Rs 20,000 in the account for a Rs 10,000 profit. You have made a 100% return on the initial Rs 10,000 investment, even though the share price rose only 50%. (Does not include fees and interest charges.)
Conversely, using a margin can also magnify losses. For example, if the share price drops 25% from Rs 20,000 to Rs 15,000 and you sell your shares, the Rs 15,000 less the Rs 10,000 borrowed leaves you with Rs 5,000 in equity. This represents a 50% loss on your initial Rs 10,000 cash investment.
If the value of the shares declines further to Rs 10,000, your loss would be 100% of your original Rs 10,000 cash investment and Rs 0 in equity.
Lastly, if the value of the shares declines further to Rs 8,000, your loss would exceed 100% of your original Rs 10,000 and, therefore, would present a net deficit of Rs 2,000 in equity. Consequently, you would owe the stockbroker the net deficit of Rs 2,000 and be required to pay the stock broker Rs 2,000 immediately.
What is a Margin Call?
When you do margin trading, you would have to maintain a minimum margin, also known as the maintenance margin requirement, which requires you to maintain a certain percentage of equity in your account. Your broker will hit you with a margin call when your portfolio falls below the maintenance margin, usually due to declining security prices.
Once you’ve received a margin call, you have a few options:
- Deposit additional cash into your account up to the maintenance margin level
- Transfer additional securities into your account up to the maintenance margin level
- Sell securities (possibly at depressed prices) to make up the shortfall
If you cannot meet the margin call fast enough to satisfy your broker, it may be able to sell securities without your permission to make up for the shortfall. Depending upon your trade and position type, a customer may need to respond to a margin call immediately, within the same trading day, or a maximum of one or two trading days.
Example: Margin Call
Let’s say you’ve deposited Rs 10,000 into your account and borrowed another Rs 10,000 on margin from your broker. You decide to take your Rs 20,000 and invest it in 200 shares of A ltd. trading for Rs 100 a share. Your maintenance margin is 30 percent.
Minimum Account value to avoid margin call = Margin Loan / (1-Maintenance Margin)
=Rs 10,000/ (1-30%)
=Rs 10,000/ 70%
=Rs 14, 285.71
Share price at which margin call would be generated
= Minimum Account Value / Number of Shares
= Rs 14,285.71 / 200
= Rs 71.42
In this example, if the account’s market value falls below Rs 14,285.71, you’ll be at risk of a margin call. So, if the stock price of A Ltd. falls to Rs 71.42 or lower, you’ll be faced with a margin call.
Let’s say Company A Ltd. reports disappointing earnings results, and the stock falls to Rs 60 not long after you bought it. The account’s value is now Rs 12,000, or 200 shares at Rs 60 per share, and you’re Rs 1,600 short of the 30 percent margin requirement. You have a few options.
- Deposit Rs 1,600 cash into the account to meet the margin call.
- Transfer Rs 1,600 of securities into the account.
- Sell Rs 3,333.33 of XYZ stock to pay down the margin loan and boost your account equity to the 30 percent requirement.
Rs 12,000= X/ (1-30%)
Rs 12,000= X / 0.7
Rs 12,000*0.7
X =Rs 8,400
Here, X= Reduced Loan amount
The initial Loan amount was Rs 10,000
A shortfall of Rs 1,600 and this need to be paid to the stockbroker as a margin call.
It should be noted that these are the minimum requirements to bring you back into compliance with the maintenance margin. If the stock continues to decline, you’ll need additional equity.
It’s important to remember that the broker will be paid back in full for its loan, and any losses are entirely yours. In this example, you deposited Rs 10,000 of your own money and borrowed another Rs 10,000 on margin. The account value declined to Rs 12,000, leaving you with just Rs 2,000 in equity and a decline of 80 percent, despite the stock only falling 40 percent.
Cost of Using Margin Funding and Interest Charges
Interest will be charged to your account for the amount lent by the stockbroker. The interest charge will be calculated on your daily loan balance, which is your debit balance. However, this interest rate may vary. Some stockbrokers may charge less at par with bank lending rates, and others may charge higher. Remember, banks may not provide loans for margin trading. This type of funding, i.e., margin funding, is usually only offered by stockbrokers. Therefore, an increase in rates will result in an increased borrowing cost. For more information, please see the Credit Terms & Conditions in your brokerage account or check with the relationship manager of your stockbroker.
Bottom-line: Margin Trading Is A Leveraged Trading. Be Cautious!
For traders and investors, margin can come in handy when potential opportunities arise. Margin can increase buying power and enable access to advanced trading strategies. Below are our tips:
- Review your investment objectives.
- Do your research, making an informed decision on whether you want to margin trade or not.
- Understand your risk tolerance.
Margin trading could be risky. They should be used in moderation, for limited positions, and short periods because even the pros are not good at guessing the market over time.
