What is Margin Trading and why you should use it

Leveraging your existing assets with your stockbroker can significantly improve your ROI

Ever wondered if you could get money interest-free? After all, you only need the cash to make an investment and you are ready to provide a guarantee by pledging your assets.

Well, in the stock markets, margin trading is precisely that. It is trading with borrowed assets.

Investors pledge their current investments (usually stocks or mutual funds) with their broker who in turn gives interest-free cash or ‘margin’ to trade. This way an investor does not have to infuse fresh money or sell existing assets to make a new investment.

What’s the advantage for the Investor? Better ROI

Margin trading, when done right, improves your Return on Investment significantly. Let’s take an example:

Suppose you had Rs.10,000 in Mutual Funds and you go to your broker and pledge them. Against that Rs.10,000, your broker lends you Rs.8,000 (a 20% haircut, since the broker can’t risk your shares falling in value).

You then use this margin to buy a 100 shares of Tata Motors trading at Rs.80.

Now, when the price of Tata Motors goes up to Rs.90, you are making a profit of Rs.10 per share.

Total Profit = Rs.10 x 100 shares = Rs.1,000

Total Investment = Rs.10,000

Return on Investment (Profit / Investment) = 1,000/10,000 = 10%

However, in case no margin trading had taken place i.e. the entire Rs.8,000 was invested from your own pocket, then the return on investment would have been lower.

Return on Investment = 1,000/18,000 = 5.55%

A much higher return by leveraging your investments and we haven’t even taken into account the returns given by the Mutual fund!

But why would a broker give you an interest-free loan?

It is in the interest of the broker to help you trade as possible, after all, more trading means great liquidity in the market and more revenue from brokerage and commissions.

So, do you get the entire value of your collateral as a loan?

No. Brokers generally go for what is called a ‘haircut’. Haircut implies a nominal value being deducted from the total market value of the collateral.

For example, if you pledge mutual funds worth Rs. 10,000. The broker might give a margin of Rs. 8000.

Thus a 20% haircut.

This is done to protect the broker against an unexpected fall in the value of your investments. The riskier the investment, the higher the haircut and hence lesser margin for trading.

What’s the risk?

Losses. If you lose money on the investment you made with the margin, the broker will then sell your pledged assets to make-up for the loss.

Let’s take the same example mentioned earlier,

But this time the shares of Tata Motors falls by Rs.10, and we make a loss of Rs.1000 on the borrowed margin.

Unless a sum of Rs.1000 is transferred to the broker within a set time period, they will sell some of the pledged Mutual funds to recoup the loss.

What can you pledge with your broker?

Different brokers have different types of securities eligible for pledging with them.

But in general, stocks, mutual funds and bonds (which are tradeable) which are accepted as collateral for margin funding.

Securities which entail a lock-in period such as ELSS mutual funds or fixed deposits are avoided because the broker cannot liquidate these assets if you run into losses.

So, should you go for margin trading?

Margin trading is a double-edged sword. It should be used by traders after careful consideration of their risk appetite, investment objective, and capital availability.

At Minance, we use margin trading at the core of our Assets Pay Cash (APC) product. We leverage our partner’s Mutual Funds with our broker and take very conservative derivative positions using the released margin.

Our objective is to make a return of around 12% annually (excluding the mutual fund returns) while keeping capital conservation as the chief priority.

You can learn more about Assets Pay Cash here — https://minance.com/assets-pay-cash

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