Margin trading is the process by which the trader is able to borrow funds from the brokers and use those funds to purchase securities. This form of trading provides the traders with leverage to be able to buy more securities than they can otherwise afford at any point in time.
This becomes very important for small individual traders who do not have enough capital. So, if a trader wants to purchase 2000 shares of a company which are trading at ₹150 each, he needs ₹3,00,000 straight away, that may or may not be available to him at given point in time.
In such situations, margin trading allows the trader to borrow funds from the brokers, buy these shares and keep these shares as collateral with the lender. If the shares make profits, it works well for the trader, however, if the trader ends up in losses, margin trading may end up causing him more harm than expected.
It is a two-edged sword.
The brokerage company which had borrowed the money at low rates lends it to the trader at higher rates and makes profits, also keeping the bought securities as collateral. However, the profits on the trader’s ends are not guaranteed. Because of being quite risk-prone, margin trading is regulated by various authorities like SEBI and there are various rules and regulations that have to be complied with.
Therefore, even though the trader is borrowing funds, he has to pay some part of the total value of securities with his own money. The part of the value of securities paid by the trader himself is called Margin Money.
A trader requires a margin account into which the money is to be deposited.
Initial Margin Money: As soon as the margin account is opened, the trader needs to deposit some money into the account before he starts trading on margin. This type of margin money is called the initial margin money, and it is the part of the value of the securities that the trader has to pay with his own cash or funds.
The initial margin money amount may keep on reducing in a trader’s account during the life of the trade due to his losses, but it has to remain above the minimum margin money requirement.
Minimum Margin Money: Minimum margin money is the fixed minimum amount that has to stay in the trader’s margin account throughout the trade over and above the difference between the value of the securities and the loan. The purpose of minimum margin money is to serve as the protection for the broker if the price of the securities falls beyond a certain level such that the trader is unable to cover the loan.
As soon as the money in the margin account starts going down and reaches the minimum margin level, the broker gives a margin call to the trader and asks him to top up the balance in the account through variable margin money, so that the account balance again reaches the initial margin money.
Margin Money Example:
A trader has a margin account and he enters into a futures contract to buy 100 shares of IBM at Rs 155 per share.
The capital required by the trader is ₹(155*100) = ₹15,500
Initial margin required is, say, 8% of the value of shares. So, the trader needs to deposit 8% of ₹15,550= ₹1,244 into the margin account as initial margin money.
Now, if the price of IBM shares increases by ₹5 on the first day, the profit earned of ₹(5*100)=₹500 gets directly added to the margin balance of the trader and the margin balance becomes ₹(1244+500)= ₹1744, which is a good return on capital.
But on the other hand, if the price of the IBM shares falls by, say ₹8 per share, then the loss of ₹(8*100) = ₹800 will be deducted from the initial margin to make it ₹(1244 – 800) = ₹444. This amount goes less than the minimum margin amount of, say 4% of ₹15,550= ₹622.
At this point, a margin call will be made and the trader will have to deposit a variable margin amount of ₹800 to keep the account balance equal to initial margin requirement.
Therefore, margin money has good potential to provide the traders with leverage to make more purchases than they have the capital for, but they may also end up in unanticipated losses, more than they have the appetite for.
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