what is it?
When an investor borrows money from his broker to buy stocks, the process is called margin trading. For instance, suppose you wish to buy 100 shares of a company trading at Rs1,000 on 19 November. Normally, to buy 100 shares you would need to pay Rs1 lakh to the broker. Let’s assume you only have Rs50,000, but still want the 100 shares. In such a scenario, you ask your broker to fund the remaining balance. In other words, you take a loan of Rs50,000 to buy the 50 extra shares. This loan is the margin amount funded by the broker.
Brokers, typically, charge 1.5-2% per month on the loan amount. Remember that the shares you buy on a loan will be held as collateral by the broker.
who does margin trading?
It is always advisable not to borrow money and invest, but investors and traders take margins to enhance their returns and exposure on their investment. The stock exchanges have provided this method of buying stocks for people who don’t have enough capital.
In practice, margin trading is done in the derivative segment of the market. The derivative segment is that part of the market, where you cannot take the delivery of shares and the settlement of contracts is settled through cash. For example, if you were to buy 200 shares of a company in the derivative or futures market, which is trading at Rs1,000, you will need about Rs2 lakh. But if you buy a future contract, you only need to pay a margin of, say, 15% (this differs for every stock). Therefore, by investing just Rs30,000, you are actually taking an exposure of Rs2 lakh.
Downside and risks
If the stock price falls, there are chances that you could lose your investment corpus as the broker holds the right to sell off your shares. When the stock price falls, brokers usually ask the investor to put more money in the account or they sell the shares to balance off their loss. They can do this without even notifying you. This means you lose the chance to make up for your losses later when the price of the stock goes up later.
Moreover, you need to pay interest on the loan you have taken, apart from the broker’s commission.