Margin calls: it’s the time when you have to pay back the piper

Margin calls: it’s the time when you have to pay back the piper
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First Published: Sun, Mar 09 2008. 11 08 PM IST

Updated: Sun, Mar 09 2008. 11 08 PM IST
Blessed is the person who does margin trading in the stock market without ever getting a margin call. Not getting trapped while fishing with a borrowed net is surely a good sign. But there’s no way of completely avoiding margin calls. At these moments, you wonder why the margin bell tolls. Our friend Johnny is blissfully unaware of margin trading. Today, Jinny will make him understand how margin trading makes it possible to eat a cake even when you have saved none.
Johnny: Hi, Jinny! You look very hungry. Why are you chewing your cellphone?
Jinny: Well, I am really not happy. I am getting unwanted calls from my broker, asking for margin money. I don’t know what to do. Maybe chewing the cellphone will silence the dreaded ringtone.
Johnny: What? Since when have brokers started demanding money like the underworld?
Jinny: It’s not my broker’s fault. If you do margin trading in the stock market, there comes a time when you get margin calls. It’s simply the time to pay back the piper.
Johnny: Pay back the piper? You’re confusing me. Tell me, what is this margin trading?
Illustration: Jayachandran/ Mint
Jinny: Simply put, margin trading is trading with borrowed funds or securities. Suppose you want to trade in the stock market, but you only have Rs100. There are two options. The first: You invest your Rs100 in the stock market and take home the profit or loss you earn. The second: You use your Rs100 as margin money and take another Rs100 on loan from your broker. So, you can invest Rs200 even when you have only Rs100. You pay interest on the money you’ve borrowed and carry home the rest of the profit. More money means more profit, but beware! It can also mean more loss, if your investment goes wrong. In that case, you should be ready to pay back the piper.
Johnny: It seems margin calls start buzzing when your investment goes wrong. But what sets the trigger?
Jinny: The Rs100 you brought to the table upfront is called “initial margin”. This determines how much money you can borrow from your broker. For the Indian stock market, the initial margin prescribed for trading in the spot market is 50%. This means you can borrow exactly the same amount you bring upfront to the table. Once you’ve invested all the money, you are required to maintain 40% “maintenance margin” with your broker. This means you are required to keep a minimum amount of equity in your margin account all the time. This equity represents the value of securities in your account minus what you owe the broker. In the Indian stock market, the equity in your account shouldn’t fall below 40% of the total market value of your investment. If it does, the margin call gets triggered. In that case, you’ll have to chip in additional money or security to cover the gap. I hope you now understand why I am worried about margin calls.
Johnny: Things would become clearer if you could explain by an example!
Jinny: Suppose I’ve used Rs100 as an initial margin to borrow Rs100 more from my broker. I’ve invested Rs200 in securities. The market value of my investment tomorrow rises to Rs300. Suppose I keep all my securities in the margin account, what would be the value of my equity? Well, it would be Rs300 minus the Rs100 that I owe the broker, which is Rs200. What would be the maintenance margin required? It would be 40% of Rs300, which is Rs120. The value of my equity is far more than the maintenance margin required and hence, there would be no margin call. Now take an opposite case. Suppose the market value of my investment falls to Rs120. In that case, the value of my equity would be Rs120 minus Rs100, which is equal to Rs20. The maintenance margin required is 40% of Rs120, which is Rs48. This will trigger a margin call and you’d be required to meet the shortfall. If you don’t, your broker will sell your securities for whatever price it is worth. That’s why it is important to pay back the piper on time.
What:Margin trading is trading with borrowed funds or securities.
How:The margin trader has to pay upfront margin known as “initial margin”. Subsequently, he has to keep a “maintenance margin” with the broker.
How much:For the Indian stock market, the initial margin prescribed for trading in the spot market is 50% and maintenance margin is 40%.
Who:Corporate brokers with net worth of at least Rs3 crore are eligible for providing margin trading facility to their clients.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Mar 09 2008. 11 08 PM IST
More Topics: Margin Calls | Piper | Stocks | Equities | Underworld |