Demat account: What is leverage trading and how does it work? MintGenie explains
Trading and investing through demat accounts involve distinct strategies. Margin trading empowers investors to control larger market positions with borrowed funds, amplifying both gains and losses. Derivative trading with leverage can lead to higher returns but also carries significant risks.
By utilising a demat account for leverage, you can employ a potent strategy that may significantly boost your potential returns while trading in the stock market. Leverage empowers investors to command a larger market position with a relatively modest capital investment, magnifying both profits and losses.
Leverage akin to a double-edged sword must be wielded judiciously to navigate the volatile waters of finance without succumbing to substantial losses. Embarking on the leverage trading journey through a demat account opens doors to lucrative opportunities, yet it demands a steady hand to steer clear of financial pitfalls.
Before delving into the benefits of using a demat account for leverage trading or margin trading, it's crucial to understand the distinction between trading and investing.
Trading vs. investing
Trading involves frequent buying and selling of shares to profit from short-term stock price fluctuations, while investing entails purchasing company shares with the aim of becoming a shareholder and participating in the company's growth over the long term, potentially earning capital gains through stock appreciation and dividends.
For example, if you buy a share and sell it for a profit within a short period, it's considered trading; holding onto the share for a longer duration qualifies as investing. The demat account serves as the storage space for these shares.
Demat and trading accounts are separate offerings provided by depository participants. If you're a trader, you can open a trading account, while investors typically opt for a demat account.
Depository participants (DPs), or stockbrokers, act as intermediaries between individuals and depositories, facilitating the creation and management of demat and trading accounts. You can open a trading account alone if you're solely interested in trading.
However, in recent times, depository participants have been offering combined two-in-one accounts, integrating a trading account with a demat account for enhanced convenience.
What is leverage trading?
Leverage trading, or margin trading, allows investors to borrow funds from their broker to purchase securities, effectively leveraging their investment capital. With margin trading, investors can control a larger position in the market than they would be able to with their own funds alone.
This can magnify gains if the market moves in the investor's favor, but it also increases the risk of significant losses if the market moves against them.
Derivative trading
Another way to use leverage through a demat account is through trading futures and options. Futures and options contracts give investors the right to buy or sell an underlying security at a predetermined price within a specified period.
By purchasing these contracts, investors can control a larger position in the underlying security with a smaller amount of capital. Futures and options trading can be highly leveraged, as the potential returns are often much higher than the initial investment.
However, derivative trading also carries significant risks, including the potential for loss of the entire investment if these contracts expire worthless.
Using demat account for leverage trading
For example, if you have ₹10,000 in your demat account, the brokerage may allow you to trade with more than ten times that amount. Essentially, by using this facility, you're borrowing funds from the broker to invest in stocks.
Brokers offer funds to their clients because it enables them to earn more money through transaction fees. They charge transaction fees for both buying and selling. In this scenario, if you borrow ₹90,000 from the broker and trade for ₹1,00,000, transaction charges will apply to both the buying and selling transactions, totaling ₹2,00,000.
Regardless of whether you make a profit or a loss, the broker will deduct transaction charges. Meanwhile, the transaction fee for derivatives depends on how many lots you have bought and sold.
FAQs
What is leverage?
Leverage is the use of borrowed capital, such as margin, to increase the potential return on investment. It allows investors to control a larger position in the market with a smaller amount of their own capital. Leverage magnifies both gains and losses, amplifying the potential return on investment while also increasing the level of risk.
Is using too much leverage good for trading?
Using too much leverage can be risky for trading. While leverage has the potential to amplify profits, it also magnifies losses. If the market moves against the trader, losses can accumulate quickly, and excessive leverage can result in substantial financial losses or even the loss of the entire investment. It's essential for traders to use leverage responsibly and to have a solid risk management strategy in place.
How much leverage margin does the broker offer?
The amount of leverage offered by a brokerage can vary depending on the broker and the type of account. Typically, brokers offer leverage ratios ranging from 2:1 to 50:1 or higher for trading in various financial markets.
However, the specific leverage margin provided by a brokerage may depend on factors such as the trader's account size, trading experience, and the type of assets being traded.
Can I use leverage trading in derivatives?
Yes, leverage is commonly used in derivative trading. Derivatives such as futures and options contracts allow traders to control a large position in the underlying asset with a relatively small amount of capital, thus providing leverage.
However, trading derivatives with leverage also carries significant risks, as losses can exceed the initial investment. Traders should be aware of the risks involved and use leverage responsibly when trading derivatives.
Who regulates the derivative market in India?
The derivatives market in India is regulated by the Securities and Exchange Board of India (SEBI), which is the primary regulatory authority overseeing the securities and commodities markets in the country. SEBI formulates rules and regulations governing derivative trading to ensure fair and transparent market practices and protect the interests of investors.
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