Is Margin Trading too risky?

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With the introduction of derivatives trading in India from the year 2000, more and more people have tried their luck with trading in derivatives with varying degrees of success.

One of the most important facets of trading in derivatives is that it is capital intensive i.e, it requires a large amount of capital to be a profitable derivatives trader. This caused a need for the availability of finance and improved liquidity in the stock market.

Hence, in April 2004 SEBI introduced margin trading and securities lending schemes which allowed corporate broking entities to directly lend funds to investors to finance their trading in the cash markets which was subject to regulations.

Fast forward to 2019, margin trading has evolved from a need to a necessity for all traders trading in high volumes causing the demand for higher margins/exposure to explode.


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Risk and Reward

Like any game that involves gambling like blackjack or poker, you would want to increase your bet if you see great potential in the hand. However, this does not ensure that you will win the hand and hence its considered risky.

In such a scenario, the stakes are very high and so are the profits. Hence, the risk of losing money is very high too.

That being said, it doesn’t mean that margin trading is gambling but there are some important lessons to be learnt while doing margin trading.

Margin trading is a highly risky strategy that can yield a high profit if executed correctly. Hence, it is imperative to have a good strategy. Because, if your strategy works it can give you very high returns but on the flip side you can lose a lot of someone else’s money, which is why it is very important to invest only those stocks which you have researched about.

Always remember to only buy those stocks on margin which you have a good understanding of.

What is Margin Trading?

Buying stocks on margin involves borrowing money from a broker to invest in the stock market. A margin account increases the chances of making more money by investing in stocks as the trader is leveraging the broker’s capital to earn more profits. As a result, margin trading is generally considered more profitable than general trading but also comes with greater risks.

Margin trading amplifies the effect of losses on your portfolio and brokers may issue a margin call which requires you to liquidate your positions or pay additional capital to the broker to continue trading. Hence, one should only use margin trading to invest in stocks with which they are extremely confident about.

Most experienced traders look for brokers which provide high margin coupled with low brokerage so they can maximize their profits.

Risks associated with Margin Trading

Suppose you have Rs.100,000 in your margin account but you want to buy a stock that costs more than that. SEBI has a mandate of keeping 50% initial margin. As a result, you can borrow another Rs. 100,000 from the broker, giving you the ability to buy 200,000 worth of stock, doubling your purchasing power.

However, owning twice the amount of stock than you could originally purchase doesn’t mean that you will be able to double, triple or quadruple your profits as there are certain risks associated with it, mentioned below:

Amplified Losses

It is no hidden fact that margin trading can significantly increase the gains of an investor, however, it can severely amplify their losses as well, so much so that they can lose more than what they originally invested.

Some traders prefer lending from brokers rather than banks or lending institutions, however, this type of debt is even more binding then lending from traditional institutions.

Margin Call

A margin call is when a broker asks a trader to add more funds to a margin account so that it reaches the maintenance margin level. If the borrower’s securities do not perform well and go below a certain level, then the broker may ask the borrower to either liquidate his position or add funds to his margin account to meet the margin call.

Liquidation

Depending on the terms of the margin loan agreement, the broker can ask the borrower to liquidate his position, if they are unable to meet the margin call. This is the worst-case scenario and both parties end up losing a lot of money.

The Bottom Line

Margin Trading allows investors to increase their purchasing power by providing them with more capital to invest in stocks. But it is certainly a riskier than traditional forms of trading. Investors interested in margin trading should tread carefully as one should only invest the amount of money that they can afford to pay back in case of losses.

Also, investors should also be prepared for eventualities like a margin call. But always keep in mind that if it’s done efficiently it can offer various benefits like the opportunity to diversify your portfolio.

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