Margin Trading Facility: Definition, Benefits, and Risks

What is Margin Trading Facility (MTF)?

Margin trading facility is an approved product by the exchange. With its help you can buy stocks by only paying part of the total amount. The remaining amount comes from the broker by charging an interest on the loan.

How does Margin Trading Facility work?

Let’s say you want to buy shares worth ₹4000, but you have only ₹1000. This is where margin trading facility can help you. Usually, you need to provide 25% of ₹4000 as your initial investment, which amounts to ₹1000. But this percentage can increase depending on the stock. For our example, let’s go with 25%. The broker will then loan you the remaining ₹3000 (75% of ₹4000). With MTF, you can now purchase ₹4000 worth of shares with just ₹1000 in your pocket. But do remember that the stocks must be verified (pledged with the broker) as per SEBI guidelines to purchase under MTF.

Advantages of Margin Trading

Now that you know what margin trading is and how it works, let us look at some of its advantages:

• Higher Buying Power It enhances your buying power by several notches with extra funds available in your account. With it, you can expand your investments by acquiring more shares or other financial instruments than your available capital would permit.

• Greater Growth Potential With MTF, you can get a growth on returns as you will have access to more capital. But on the flip side, there’s also a possibility to incur losses.

• Good Portfolio Mix Having a good diversified portfolio helps in effective risk mitigation. With margin trading, you can invest in various stocks across industry verticals and also add other financial assets in your investment portfolio. All of these go a long way in helping you diversify your portfolio and bringing down risks.

Risks of Margin Trading

• Increased Chance of Losses While MTF can increase your earning potential, it also means that if the stock price drops, you could face losses greater than your initial investment, putting your money at higher risk.

• Mandatory Minimum Balance You need to maintain a minimum balance in your trading account. If your stock incurs a loss or the minimum margin requirement rises, you will be required to add funds.

• Risk of Liquidation If your balance drops below the minimum requirement, your broker will ask you to maintain balance. If you can’t, you might need to sell some or all assets to meet the minimum balance requirement. Brokers can initiate action against you if you fail to honour the terms and conditions of the margin trade agreement. In that case, your broker can liquidate your assets to recover the money lent.

• Interest Payment When you borrow money through MTF it comes with an interest. This interest could eat into your profits and it can it can increase costs over time if you hold on to MTF positions for too long.

New SEBI Regulations on Margin Trading

SEBI has introduced a few new rules for margin trading. They are as follows:

• Cash collateral Securities funded by cash collateral can be used as maintenance margin, reducing the need for additional collateral. However, these securities must be from Group 1, a list of high-quality stocks. The margin requirement for these securities is calculated using a combination of Value at Risk (VaR) and Extreme Loss Margin.

• Pledged shares Shares are directly pledged to the clearing corporation, CDSL or NSDL, instead of being transferred to the broker's account. This allows investors to retain all corporate benefits on their shares.

• Upfront margin Brokers are required to collect margins from investors upfront for any buying or selling of shares.

• Power of Attorney (POA) Investors are no longer required to assign a POA to brokers.

• Margin loan Investors must pay a minimum 20% margin upfront in the cash segment for availing a margin loan.

• Intraday profits Investors can only use intraday profits to make new positions after T+2 days.

• Index contracts Traders will see an additional 2% margin requirement on their positions in index contracts

To sum it up, the process of margin trading is quite straightforward. In fact, if used effectively, margin trading can help boost your portfolio. But always approach it with a clear goal and stay vigilant about shifts in the market. Anything in excess is bad and that goes for borrowing as well. And keep an eagle’s eye on your investments to make informed choices.