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Beware of the pitfalls of margin trading

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  • Margin or leveraged trading comes with huge inherent risks as it involves taking on debt, which can magnify investors’ profits as well as losses
  • For the majority of retail investors, margin trading could be a short route to lose money because of the risks

Recently, a 20-year-old student in the US committed suicide allegedly after seeing a negative balance of $750,000 in his trading account, according to media reports. The student was trading options using an app popular among retail investors in the US.

Several economies, including India, have seen a surge in stock trading post the covid-19-related lockdowns. Stockbrokers on the National Stock Exchange (NSE) added 800,000 active customers in just the first two months of financial year 2020-21. In comparison, in all of FY20, NSE added about 2 million active clients.

Equity investing can build wealth over the long term but leveraged or margin trading is a high-risk method of participating in the market. We explain what margin trading is and why you should avoid it.

What’s margin trading?

When you buy a stock, you can pay the entire price upfront. However, you can also buy it “on margin" or pay only a fraction of its price (called margin) and borrow money from the broker to finance the rest.

This allows you to do much bigger trades than what your cash levels permit. So, if you have 100, you can buy stocks worth just 100 in the cash trade or buy stocks worth 500 by borrowing the balance 400 from your broker.

The lending is usually couched in technical jargon. It commonly takes three forms—intraday trading, futures trading and options trading.

Under intraday trading, the money is lent for the day and you must buy and sell the stock within the same day. Completing the buy and sell transaction automatically repays the loan but you may have to sell the share at a loss.

Under futures trading, you buy or sell a futures contract. This means that you agree to buy or sell a certain number of shares or the index itself at a predetermined price on a predetermined date.

Options trading is about buying or selling an options contract. Buying an options contract means you get the right but not the obligation to buy or sell a certain number of shares at a particular price. In return for acquiring this right, you pay a fixed premium. Selling an options contract is the reverse of this. It is particularly risky because the upside is capped in such transactions but not the downside.

The contracts require you to deposit a fraction of the purchase or sale price as margin. Another technical word to describe all these transactions is “leveraged trading".

As digital brokers have rapidly added clients over the past few years, the number of margin trading accounts has also surged. “Our user base has grown 10 times in the last two years, from 100,000 in June 2018 to 1 million in June 2020. Trading volumes, in particular, have picked up two times since the lockdown in March. About 75% of our users are in tier II and tier III cities," said Ravi Kumar, co-founder and CEO of Upstox, a digital brokerage firm.

However, margin trading as a proportion of the brokerage’s customer base has fallen. “Around 35% of our users trade in futures and options and this percentage has actually decreased over the past few months, while equity has increased," he said. Note that even a lower percentage of a rising base can translate into growing numbers of margin traders in absolute terms.

Why is it risky?

Margin trading involves taking on debt and, hence, magnifies your profits as well as losses.

In the previous example, a 10% decline in the stock in cash trade will cost you 10. However, in a leveraged trade, it will cost you 50. In addition, a sharp swing in price can also lead the broker to demand additional margin from you. If you are unable to furnish this margin, the broker, typically, “closes" your position or sells your stocks, to protect himself from default. These sales often occur when the stock has been hit hard. When you pay upfront in cash, the worst-case scenario would be losing your investment. In a margin trade, it could be losing your investment and also ending up with debt.

Shyam Sekhar, founder and chief ideator, iThought Advisory, said contracts like futures and options are “zero sum" games where your profits are mirrored by losses in the books of someone else. “In trading, you don’t know who you are up against," he said. Often, you may be against a sophisticated trader or algorithm who knows more about the stock or the market than you.

A lot of retail margin traders rely on technical analysis (TA) or the study of price and volume charts to make their decisions. However, many financial advisers are wary of relying on these methods. “TA simply tells you what the mob is thinking but the mob is very often wrong. For example, TA was indicating a buy on Yes Bank at around 300-400 per share," said Sekhar.

“TA has zero validity. It can produce favourable outcomes on some occasions, but that is sheer luck. Just ask yourself how many billionaires built fortunes by applying it," said Vikas Gupta, CEO and chief investment strategist, Omniscience Capital, a Sebi-registered investment adviser. However, some traders see TA as a valid instrument of analysis.

Margin trading, at best, works for a small group of highly sophisticated traders.

Anand Rathi, founder, Augment Capital Advisors LLP, who is now a financial adviser, started leveraged trading in 2010 and made huge losses in the second year. “It took me three-four years to start making money and build an automated system to execute it," said Rathi.

Raja Ambrish, 26, who is now a full-time stock market trader, started leveraged trading when he was working as a data analyst at a large company. “I would pick stocks randomly and take intraday positions. Sudden market moves would wipe out profits and sometimes even cost me a month’s salary," he said. Ambrish currently makes money from trading but he has academic qualifications in economics, a job in data science and has put in multiple years of effort and suffered periods of losses.

Moreover, there is no way to verify how lucrative trading is, like you can do through net asset values (NAVs) in mutual funds, because this information is not publicly reported or audited by an independent third party.

For the majority of retail investors, margin trading could be a short route to lose money. If you want to build wealth for the long term, it may be best to stick to the old-fashioned cash market.

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