A lot of people, when they are about to open a trading account, get tempted by the idea of buying on margin. They come across promotions by brokers telling them to use a margin trading facility (MTF). However, they need to know the risks and rewards of this facility before using it.
What Is A Margin Trading Facility (Mtf) And How Does It Work?
An MTF is a loan facility provided by a stockbroker that allows an investor to purchase more shares than his own funds permit. Let us take an example to understand it thoroughly.
Suppose you notice that a stock is trading at ₹100 and you have ₹500 in your trading account. You think the probability of its price rising is very high.
Therefore, you want to buy 10 units of this stock, but that would require you to have ₹1,000. Hence, your broker steps in and tells you that you can borrow ₹500 from him to buy the stock worth ₹1,000.
As margin trading is like any loan, your broker will make you pay interest on the MTF. But, that is not all. What if the price of the stock falls? In that case, it is you who will bear the loss and not your broker. Similarly, if the stock price rises, you will benefit from it, not your broker.
Let us say that you buy 10 units of the stock by putting ₹500 of your own and borrowing ₹500 from your broker. The stock’s price rises to ₹120. Hence, your investment is worth ₹1,200 (120*10), which means you have earned a profit of 40% (200/500).
However, if you had invested ₹1,000 of your own, your profit would have been 20% (200/1,000). This is how margin trading amplifies your profit. But, be careful because it can also amplify your losses.
Suppose the stock’s price falls to ₹70. The value of your investment is ₹700 (70*10), which means you have incurred a loss of 60% (300/500). Had you invested ₹1,000 of your own without borrowing from your broker, your loss would have been 30% (300/1000). Hence, MTF can magnify your losses.
What Should A Trader Be Careful Of While Using An Mtf?
By now, you would have understood that margin trading becomes risky if the price of a stock you have bought starts falling. If the stock price begins to fall, both your capital and your broker’s capital are at risk.
Therefore, while providing you with an MTF, a broker will let you know that if a stock price falls beyond a limit, he will issue a margin call. When a margin call is issued, your broker tells you to deposit more funds.
As the stock’s price falls, your investment’s value declines, exposing your broker to risk. To cover for it, he has to tell you to deposit more money. So, you will have to lock in more funds when the stock’s price falls.
In case, you are not able to do so, your broker can sell your assets, which will result in you incurring a significant loss.
Is Margin Trading For Everyone?
As margin trading involves considerable risk, it is only meant for experienced traders. Typically, it is not advised for a new trader. If you have only begun to trade, you may find it difficult to gauge the direction of the stock market. Hence, you should avoid using an MTF.
Even for experienced investors, MTF makes sense when the market is bullish. In a bullish market, stock prices tend to increase on a daily basis. Hence, you can use margin trading because the probability of a stock’s price rising is high.
By the same logic, it becomes extremely difficult to use an MTF in a bearish market when stock prices are likely to fall.
Overall, you should use an MTF only if you are sure that you will be able to bear the maximum loss of your position. If you cannot do so, you should not use an MTF.
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