How does a demat account facilitate margin funding in trading? MintGenie explains

Margin Trading Facility (MTF) is a service provided by select brokers in India that allows investors to purchase securities by paying only a portion of the total transaction value, known as the margin. This margin can be paid either in cash or through shares held as collateral.

In this facility, the broker finances the remaining portion of the transaction as a loan and applies daily interest charges to it. The securities acquired through MTF are held as collateral by the broker until the investor repays the loan in full.

Consider a scenario where an investor aims to purchase shares valued at ₹20 lakh, but their account holds only ₹2 lakh. Utilising the Margin Trading Facility, they can acquire the shares by providing ₹2 lakh as the margin and securing a loan of ₹18 lakh from the broker.

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In this case, the investor leverages their initial investment by 10 times, thereby expanding their potential profits significantly. By increasing the order size from ₹2 lakh to Rs. 20 lakh, they amplify their profit potential.

Retail investors have the option to acquire stocks by paying 25% of the total value, with brokers financing the remaining amount for a duration of up to one year. The interest rate imposed by brokers varies between 7% and 18%, contingent upon the client's risk profile.

Many brokers offer MTF for approximately 1,000 stocks listed in the Indian stock market. 

In India, margin trading has seen a sharp rise due to increased participation from retail investors. With the Indian economy growing robustly, individuals have more disposable income, and many are choosing to invest in the stock market.

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In January, the margin trade funding book for the stockbroking industry has surged to Rs. 54,537 crore, marking a substantial leap from Rs. 29,500 crore recorded in January last year and a significant jump from about ₹7,100 crore in February 2020, according to data compiled by ratings firm ICRA.

Steps to use Margin Trading Facility

Activate Margin Trading Facility: Investors need to activate the margin trading facility with their broker. This may involve signing additional agreements or documents specifying the terms and conditions of margin trading.

Fulfill Margin Requirements: Before initiating any margin trades, the individual must ensure that they meet the margin requirements set by the broker. This typically involves maintaining a certain percentage of the total transaction value as a margin, either in cash or as collateral in the form of securities.

Place Margin Orders: With the margin trading facility activated and margin requirements fulfilled, the individual can place margin orders through their trading account. These orders allow them to buy securities by paying only a fraction of the total transaction value upfront, with the remaining amount funded by the broker as a loan.

Monitor Margin Levels: Throughout the trading period, the individual needs to monitor their margin levels closely. If the value of the securities held in the demat account falls below the maintenance margin level, the broker may issue a margin call, requiring the individual to deposit additional funds or securities to restore the required margin level.

Manage Positions: While using margin trading, it's crucial for individuals to manage their positions effectively to minimise risks. This includes setting stop-loss orders to limit potential losses and regularly reviewing the performance of their margin trades.

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Repay Margin Loan: At the end of the borrowing period, typically up to one year, the individual needs to settle the margin loan by either selling the securities purchased through margin trading or by depositing funds into their trading account to repay the borrowed amount.

Risk: While margin funding can amplify potential returns by allowing investors to increase their purchasing power, it also involves increased risk. If the value of the securities held in the investor's account declines, they may be required to deposit additional funds or securities to maintain the required margin level. Failure to do so may result in a margin call, where the broker liquidates the investor's securities to cover the outstanding loan amount.

Margin funding vs. leveraged trading 

Margin funding involves borrowing funds from a broker to purchase securities, using the investor's existing securities or cash as collateral. Leverage trading involves using borrowed funds (leverage) to speculate on short-term price movements in financial instruments such as stocks, currencies, or commodities.

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Leverage trading enables investors to control larger positions with a smaller amount of capital, thereby magnifying potential gains (or losses) from small price movements.

It is often employed by traders seeking to capitalise on short-term market fluctuations, and positions are typically opened and closed within a short time frame.

FAQs

Is margin trading risky?

Yes, margin trading involves a higher level of risk compared to regular cash trading. By borrowing funds to leverage investments, investors can amplify both gains and losses. If the market moves against them, they may incur significant losses and even risk losing more than their initial investment.

Do investors opt for margin facility stocks instead of cash?

Some investors choose to utilise margin facilities to leverage their investments rather than solely relying on cash. By using their existing securities as collateral, they can borrow funds to increase their purchasing power in the market. This allows them to potentially amplify returns but also exposes them to higher risk.

Who determines the margin amount to be paid?

The margin amount to be paid is typically determined by the broker or financial institution providing the margin facility. It is calculated based on factors such as the value of the securities being purchased, the margin requirement set by the broker, and the investor's existing portfolio. The margin amount represents the portion of the total purchase price that must be funded by the investor's own capital, with the remainder borrowed through the margin facility.

What are the implications if the price of a stock is purchased using a margin facility?

If the price of a stock bought through a margin facility rises, the investor may realise gains on their investment. They can sell the stock at a higher price, potentially making a profit. However, if the stock price falls, the investor may incur losses. 

If the value of the securities held as collateral falls below a certain threshold, the investor may receive a margin call from their broker, requiring them to deposit additional funds or securities to maintain the required margin level. 

If the investor fails to meet the margin call, the broker may liquidate the securities in the investor's account to cover the outstanding loan amount, potentially resulting in losses for the investor.

Who receives corporate benefits on the pledged securities?

The pledgor continues to remain the beneficial owner of the pledged securities and will, therefore, be receiving corporate benefits during the period of the pledge.