What is a Margin Trading Facility? Advantages and Disadvantages

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Margin Trading

In the field of finance, the margin is the collateral that is deposited with a broker by an investor in order to cover any credit risk that the holder may pose for the broker (or the exchange). 

In case investors wish to borrow capital from their broker to purchase or trade in any financial instruments, borrow financial instruments so that they can sell them short, or trade in derivatives contracts, they create a credit risk if their trades potentially fail to gain returns. 

Once an investor open demat account and a linked trading account with a broker, the investor may avail of a margin trading facility. 

Buying on a Margin

Commonly, availing of a margin trading facility is called ‘buying on a margin’. This occurs when an investor purchases an asset by borrowing some money (the balance required) from a broker. 

Buying on a margin actually refers to any initial payment that is made by the investor to the broker for buying the security or asset in question. 

The margin trading facility in the area of financial markets and trading or investing should not be confused with the margin as it is employed in a general business context. 

In such a context, the margin is essentially the difference between a product or service’s selling price and the actual cost of production (or a profit-to-revenue ratio). 

In a trading and investing context, ‘margin trading’ is the practice of borrowing capital from a broker to trade a financial security or asset. The collateral for the amount borrowed becomes the actual asset/equity that the funds have been borrowed to buy. 

An Example of Buying on a Margin

Knowing how to trade online is simple enough these days, but if investors wish to use certain facilities while trading, they must learn about concepts like margin and the margin trading facility. Margin trading can be explained by an illustrated example:

Say, an investor wishes to buy securities worth ₹10,000. The investor may have 60% of the funds to buy the securities, that is, ₹6,000. The rest will have to be borrowed from the broker, ₹4,000, to buy the securities. The rest of the capital that is borrowed to buy the securities may be thought of as a loan from the broker. As any investor can avail of a margin trading facility to buy securities, they can buy more securities, like stock, than they would otherwise be able to without the margin trading facility. 

How the Process Works

When you learn how to trade online, which is an easy process to master, you can also learn about the margin trading facility and how this process works. 

To avail of a margin trading facility, investors must open a margin account with their broker. With such an account, an investor deposits cash into the account and this serves as the collateral for any loan taken from the broker to buy assets or securities.

Depending on the broker in question, an investor may borrow a certain percentage of the purchase price of an investment. Since this is a kind of loan that the broker gives an investor, the broker will charge interest on it. 

This will have to be repaid by the investor. In case an investor sells assets or securities, the proceeds will be used to repay the loan and any remaining proceeds may be kept with the investor. 

Advantages & Disadvantages of a Margin Trading Facility

Investors should be aware that there are certain benefits and drawbacks to using a margin trading facility. As with any funds borrowed, they have to be paid back. Here are some key advantages and disadvantages of trading on a margin: 

  • Advantages
  • Through margin trading, investors get the benefits of leverage and this can result in greater returns or profits
  • Margin trading increases the investor’s purchasing power
  • The margin trading facility has more flexibility, depending on the brokerage, than other types of loans
  • Disadvantages
  • Due to the power of leverage, the margin trading facility affords, there may be greater losses incurred
  • The facility incurs interest charges and other fees (account fees)
  • The process potentially leads to margin calls which may require investors to make additional investments
  • The process may lead to forced liquidations, resulting in the sale of securities 

Margin Trading Facility – Is it worth it?

Investors who are interested in amplifying their gains on trades may avail of a margin trading facility. However, using this facility may enhance the chances of losses too. 

It is important to note that trading with this facility is done with the use of borrowed funds, and if trades go south, losses may be incurred. 

The gains may be plentiful if securities go up in price, but if they happen to fall in value, the investor may end up owing more funds than what was initially offered as collateral. Hence, this facility should be used after determining an investor’s risk profile and other financial factors. 

Written by sanaya