Investors normally trade in securities using their own funds. Sometimes, based on the market conditions in stock exchange, they wish to trade beyond their owned resources. This type of trading in the securities is supported by the borrowing facility for funds and securities, in the system. In order to take leverage out of borrowed funds from brockers for trading in securities over and above owned funds, stock market regulator viz., SEBI introduced the concept called “Margin Trading”. While trading in securities using the borrowed resources, investors are required to put in place a margin (good faith deposits) with the stock brokers and such trading is called margin trading. This margin is usually a percent of the value of the proposed transaction.
Thus in simple words, margin trading means trading in securities using borrowed resources in form of funds and securities. It is a leverage mechanism that provide lending facility to their clients and are available in every stock exchanges. However business model for trading and securities lending are different in different markets.
IMPORTANCE OF MARGIN TRADING
Margin trading helps in increasing demand for and supply of securities and funds in the market, which in turn contributes towards better liquidity and smooth price formation of securities.
It also facilitates the price stability across the markets through facilitating the arbitrage. For example, in case of the mis-pricing between cash and derivatives market, margin trading supports the transactions in the cash market to facilitate the arbitrage between the cash and derivatives, which results in the better price alignment across the markets.
Margin trading also provides for the hedging facility. Take an example, if an investor holds say call options (right to buy the stocks) to be exercised only after a specific period of time, he may sell the securities in the cash market on margin trading and hedge his risk.
Considering above points, it is pertinent to note that margin trading important role in stock exchange and improves efficiency and effectiveness of whole system.
The margin trading enables an investor to trade in more securities and thus increases his profits if there is rally in share price beyond expectations. On the contrary there shall be loss if the prices crashes contrary to his target. Such system is a leverage mechanism which significant in undertaking margin trading. For example, an investor purchases Rs. 1000 worth of securities, with his own money of Rs. 500 (margin of 50%) and borrowed money of Rs. 500. If the price of the share goes up by 10%, he will earn a return of 20%. Conversely, if the price falls by 10%, he will lose 20%. Thus margin trading gives higher gains/ losses to a client depending upon above scenario.
SEBI vide circular SEBI/MRD/SE/SU/Cir-15/04 dated March 19, 2004 had prescribed framework for permitting stock brokers to provide margin trading facility to their clients. The said framework was revised on March 31, 2004 and also on March 04, 2005.
1. Open a separate Margin Trading account
A margin account with the broker must be opened by client to avail the margin trading facility.
2. Requirements of Stock Brocker
3. Securities eligible for Margin Trading
Equity Shares that are classified as ‘Group I security’ as per SEBI Master circular No. SEBI/HO/MRD/DP/CIR/P/2016/135 dated December 16, 2016, shall be eligible for margin trading facility.
4. Margin Requirement
The aforesaid agreement for margin trading provides for two types of margins namely the initial margin and the maintenance margin. The initial margin payable by the client to the Stock Broker shall be in the form of cash, cash equivalent or Group I equity shares, with appropriate hair cut as specified in SEBI Master circular no. SEBI/HO/MRD/DP/CIR/P/2016/135 dated December 16, 2016. Please note that the margin rate is the prime lending rate/ bank rate plus a mark up depending on exposure in the margin account. The initial margin is the portion of purchase value which the client deposits with lender of funds before the actual purchase. SEBI has directed stock brokers to collect an initial margin of between 15-25% of transactions even for simple buying and selling of shares, in the cash segment. For instance, if a retail investor wants to sell shares worth Rs 10 lakh, he/she may require to keep between Rs 1.5 lakh to Rs 2.5 lakh as margin deposit with the broker.
The securities so purchased must be kept as collateral with the lender and must maintain certain minimum equity shares in the margin account. The equity means net value of portfolio viz., the value of portfolio less the margin debt. This equity should be a certain percentage of market value of securities. This percentage is called maintenance margin. If the equity is less than the maintenance margin, the client is called upon to bring in the shortfall. For example, assume that the initial and maintenance margins are 40% and 20% respectively. A client has bought securities for Rs. 10,000. The price depreciates by 40%. The value of portfolio reduces to Rs. 6000. The equity becomes Rs. 1000 (Rs. 6000 – Rs. 5000 (debt)), which is less than Rs. 1,200 (20% of the value of securities). The client is required to bring in Rs. 200. When the equity in the margin account falls below the maintenance margin, the lender makes a margin call.
5. Liquidation of Securities by the Stock Broker in Case of Default by the Client
The stock broker shall list out situations/ conditions in which the securities may be liquidated and such situations/conditions shall be included in its “rights and obligations document”. The broker shall liquidate the securities, if the client fails to meet the margin call or to comply with the conditions as mentioned in this circular or specified in the aforesaid document.
ADVANTAGE OF MARGIN TRADING
RISK INVOLVED IN MARGIN TRADING
Considering leverage position in such trading, a client is likely to gain or lose a lot of money. Such risk involved in trading can be diversified with portfolio of securities. Clients faces following risk:
The lender incures loss which is limited to transaction cost that he would incur on selling the collateral. In addition to that, there may be liquidity risk that he may not be able to sell the collateral and also loss of interest on the margin debt.
Margin trading provides platform for earning high return and create a good portfolio of securities out of leveraged position if cautiously invested. It also increases investors buying positions.