Buying on margin means borrowing money from a broker to purchase stock. Margin trading allows one to buy more stock than normal. To trade on margin an account is required. The margin account is a credit based account. In an account one can avail loan to buy stocks. Marginable securities act as collateral for the loan. Securities traded in the margin account are the marginable securities. Like any other loan there is interest charged on the amount borrowed. One should read the margin agreement and understand its implications. One is required to maintain an equity amount that ranges from 50-90%. This is otherwise called as maintenance margin. There are certain costs included in margin trading. They are trade commissions, and interests charged on margin debt. Interest is calculated daily and debited in the margin account say every 15th of the month. Margin trading offers another avenue to the brokers for earning income on account of interest earned on such accounts. This keeps the brokers still in business as there is a steady decline in income from brokerage fee. With restrictions on bank financing of equities, it has become all the more important to have such a borrowing and lending mechanism in place.
Margin trading is considered risky as it does not suit everyone. This is because losses are amplified same as the gains are. Therefore there is an increase in the risk of one’s portfolio. An investor purchasing securities has to pay for them fully in cash. However, when a part of the transaction value is paid by the investor and the rest is paid by the brokerage firm, then it is called margin-based transaction. Purchasing securities by borrowing a portion of the transaction value and using the securities in portfolio as collateral is called margin trading. The transaction is done on the expectation that the stock price will either rise or fall which enables him to make greater profits. Conversely, an investor can have a short sale through margin account. In other words, it means borrowing securities from the brokerage firm with an intention to sell it, hoping that the prices win decline. The part of the transaction that the investor has to deposit with the broker is caned margin. This is considered as the initial equity in the margin account of the client or the investor.
In the developed markets, there is no concept of carry forward trading but margin trading is permitted. It means the investors can buy or sell on payment of a margin, but the trades have to be squared within the same day. The financing is usually provided by banks and financial institutions. But in India, the banks and financial institutions have a limited role while brokerage firms are prohibited from providing such finance. The solution to such need is margin trading which is strictly a loan-based transaction. Although a new concept in India, margin trading has been popular and successful in developed markets. For the first time margin trading in India was recognized as a specific banking activity under which the funds are extended to brokers for share purchases on behalf of investors. An individual limit for the broker is set and is linked to the net-worth, assets and collateral securities that have been pledged. The term for margin trading is decided by the broker and the concerned client and the rate of interest is fixed by the banks.
Credit: Investment Management-KU