Margin Trading is a term that is commonly heard when we talk about looking stock trading or about selecting the best stock broker for our self. But there are still many of us who are completely unaware of what margin trading is, how it is offered by the brokers, what is the span margin, and what is Var in stock broking.
Let us discuss about these terms so that the next time you hear about them you are not left bewildered.
What is margin trading?
Margin trading is the facility that allows the investors and traders to borrow money from the broker to purchase stocks which the investors otherwise cannot afford. It is the difference between the total value of the security held in an investors’ account and the amount of loan taken from the broker. The margin is paid by the broker either in shares or in cash.
The margin trading transactions of a trader are funded by the broker. The margins, however, can be settled later when the market positions are squared off by the trader or investor. In order to earn profit from margin trading it is essential that the trader earn profit higher than the amount of margin, else the trader is likely to suffer a loss.
For trading in margin the investors need to have a margin account with their brokers. Margin account is different from the cash account. In a regular cash account the trading takes place through the money that is held in the account. However, in case of a margin account the shares are purchased from the borrowed amount of money.
Opening a margin account can either be a part of the standard account opening agreement. If it is not included in the standard account opening then the broker needs to have your signature and specific documents for opening a margin trading account.
Buying Stocks on Margin
For buying stocks on margin you need have the initial investment amount in your account which is known as the minimum margin requirement. After all the formalities are completed the account for the investor is opened. Once the account is opened it becomes operational and the traders can borrow up to 50% of the purchase price of the stock that they wish to invest in. it is at the discretion of the trader to borrow less than 50% depending on his needs and requirements.
The sum that is taken is known as initial margin. There are some brokers who might offer you more than 50% of the purchase price of the stock. Though the offer of receiving more than 50% of the purchase price as margin seems to be lucrative, it should be avoided at all costs. Wondering why is it so? Here are the reasons for the same:
Whenever you sell the stocks purchased through margin trading the earnings that you make are transferred to your broker against the repayment of the amount of money borrowed. The sum remains with the broker until the amount borrowed is fully paid.
There is a restriction imposed that is called as the maintenance margin. It is the minimum amount balance that is required to be kept before the broker forces you to deposit more funds. When such a situation arises it is also called as margin call.
Features of Margin Trading
- Only authorized brokers have the right to offer margin trading account to investors and traders as per SEBI guidelines.
- Margin trading allows the investors to leverage position in stock trading. These leverages are not from the derivatives segment.
- Securities that can be traded on margin are predefined by SEBI and the stock exchanges.
- It is possible for the investors to create positions against margin trading in the form of cash or in the form of collaterals.
- The margins that are created can be carried forward to a maximum of N+T days. N here is the number of days the said position can be carried over and T is the number of trading days.
- The investors those are willing to do margin trading need to have MTF account with their broker.
Risks involved in Margin Trading
Following are the risks involved in margin trading:
- Liquidation: The rights of initiating an action against the investors’ remains vested in hands of the brokers in case of margin trading. This action can be exercised in case the investors fail to keep up to the margin requirements. In case the investor fails to meet the margin requirements then the broker has the right to liquidate the assets of the investors.
- Minimum Balance: The investors are required to maintain a minimum balance amount in their margin trading account. If the balance of the investor falls below the minimum balance then the broker can ask the investors to maintain the sufficient balance. In case the investors are unable to maintain the minimum balance required then they can be forced to sell a part of their assets so as to maintain the amount of minimum balance required by the broker.
- Magnification of losses: Margin trading not only magnifies an investors’ profit but also magnifies their losses. You end up losing more than what you initially invested when opting for margin trading.
What is Span and Exposure Margin?
SPAN Margin is the amount of minimum requisite margin that is blocked for futures and option writing positions as per the exchange mandate.
The Exposure margin on the other hand is the margin that is blocked over and above the SPAN margin. Exposure margin provides cushion against any MTM losses faced by the investors and traders.
Both the SPAN Margin as well as the Exposure Margin are specified by the stock exchanges themselves.
What is VaR Margin?
VaR or Value at Risk Margin is the statistic measure that quantifies the level of financial risk within a firm or stock over a specific time frame. VaR margin is a margin that is intended to cover the largest loss that can be encountered on 99% of the days.
For liquid stocks the VaR margins are based only on the volatility of the stocks while for the other stocks the volatility of the index market is also used in the computation. It is the volatility that is computed at the end of the previous trading day.
Comparison of Brokers on the basis of Margin Provided by them:
Though margin trading seems to be lucrative it is more risky than the normal stock trading. In order to exercise margin trading the investors need to have a margin trading account. Also the investors are required to have a minimum margin requirement so that they can trade smoothly. In case the investors fail to repay the amount of money borrowed from the broker as margin then it is at the discretion of the broker to recover the money by selling the assets of the investors. Only authorized brokers are capable of offering margin trading to the investors.