Margin Trading : Why is it a double-edged sword?

Phillip Carret once cautiously remarked - “I had a margin call in 1924, and I swore I would never buy on margin again.” But you must know there is much more in it than that. Margin trading, like a double-edged sword, carries the potential to create both billionaires and bankrupts. You would have even heard brokers competing with each other for this to lure people with lower margins and try to gain customers.

But, what exactly are these margins? Well, this blog shall make you familiar with this concept and illustrate how this can make you either thick or thin.

What is Margin Trading?

Margin Trading is when you buy stocks that you can’t afford. (Yep, truth is rude.) 

When you step out of your ability to afford something and yet, buy it, it is called margin trading. As Benjamin Franklin has rightly said, “A good example is the best sermon”, here’s one for you:

Suppose you are bullish on Infosys today and wish to trade that stock with Rs. 15000. Currently, Infosys is trading at Rs. 1500, so you can afford just 10 of its shares. Now, let's assume your trade was right, and the stock moves to Rs. 1530. So, your total profit will be (1530-1500) = 30 * 10 shares = Rs 300 less brokerage. Profit % = Profit/Amount invested = 300/15000 = 2%. This is how your normal trade functions.

Now let’s see how margin trading takes you from the ordinary world to the magical land of Narnia. In margin trading, your broker lends you money, and this can be used to buy more stocks. How much a broker lends was totally dependent on your broker, but not anymore! (Don’t be confused. There’s more to this, but later.)

For now, let's say your broker is ready to lend you 9x your current account balance. So whatever amount you invest from your pocket is called “margin” and the rest is “levered money” or “borrowed money”.

As your broker is ready to lever you 9x your margin, he will give 15000 * 9 = 135000.

So total amount you have is broker’s Rs 135000 + your Rs 15000 = Rs 150000

Now instead of 10 shares, you can afford 100 shares of Infosys. Profit on 100 shares would amount to (1530 - 1500) * 100 = 3000 less brokerage. Can you spot the difference?

Earlier profit was 300, and now it has magnified to 3000. If you check the profit percentages, you’ll be awestruck!

Profit % = Profit/Amount invested = 3000/15000 = 20%

Astonishing 20% return on one stock that too in just a day! Amazing, isn’t it? Compare this to FDs, which return merely 6% in the whole year.

Why do brokers allow margin trading?

Simple answer: Brokerage.

Brokerage is charged on the total amount you traded on and not on the margin money you used. Meaning, a lesser margin (or more leverage) would provide the broker more brokerage. Bazinga!

Why is Margin Trading risky?

Let’s work with the previous example again. Until this point, we only took into consideration if the trader was right in his view. What if he was wrong and the stock dipped by Rs 30 per share? A typical oops-a-daisy moment.

Your total loss would be Rs 3000 with margin and 300 without margin. It is only the traders who suffer or benefit from margins; brokers get their brokerages either-or! 

Do you now understand Philip Carret’s cautious note? Well, you could say, margin trading is just like a magnifying glass, which amplifies your profit or loss. 

To earn more profits, the brokerage industry grew more competitive, and brokers started to offer more leverage. Imagine a broker ready to offer 99x leverage.. an investor’s utopian dream!

In such a haphazard situation, it's you as well as the broker, who are going to lose money. Moreover, if the broker has lent this high leverage to thousands of other clients, the chances of broker defaulting increases. (Sob-sob)

Trust us, this isn’t something made up. Many brokers have defaulted by giving their clients high leverage. You won’t believe that the number of broker defaults in 2020 was the highest in the past two decades, and many of them were due to lesser margins. Oh boi!

Margins in Derivatives

Before we discuss margins in derivatives, it is important that you know what the derivatives market is and how products make markets more efficient. Do check out our blog on different types of financial derivatives.

In futures contracts, we have to buy shares in lots. Buying futures on a single share is not allowed. So, it is necessary for traders to have a huge corpus to invest in futures. Retailers can’t afford to invest a hefty sum upfront in the market; thus, comes the concept of margin trading in futures. 

When you buy any futures contract for the first time, you must maintain some amount in your trading account; this is called Initial Margin (IM). IM is a certain percentage of the contract value. Nothing tough! 

Initial margin is made of 2 components:

Initial margin (IM) = Span margin + Exposure margin.

‘SPAN Margin’ is the minimum margin blocked as per the exchange’s mandate, while ‘Exposure Margin’ is the cushion over and above the SPAN. The SPAN margin requirement has to be strictly maintained as long as the trader wishes to carry his position overnight/next day.

What is Mark-to-Market in margin trading?

The share prices change daily, and so does the futures price, which ultimately leads to change in IMs. (It’s all connected!) This makes it necessary to apply the concept of Mark-to-Market (M2M) to reduce the counterparty default risk drastically.

Don't get confused with so many new jargons coming in. For now, just know that IM is the minimum money required to enter into a futures contract, and IM changes every day.

Secondly, as the IM changes every day, it becomes necessary to settle the PnL accounts daily, and this settlement of PnL is called M2M. Still puzzled? Don’t worry. Let us go back to Infy’s example for a better understanding.

Beginning of Day-1

Suppose, its futures contract was trading at 1600 with lot size 600. 

Contract Value = 1600 * 600 = 960000

Assume IM to be 20% of contract value. 

IM req = 192000. You need to have at least 192000 in your trading account to enter into this contract.

Amount frozen as IM = 192000

End of Day-1

Futures close at 1610. 

As you earned a profit, it will be credited to your account that day itself. 

Profit = (1610 - 1600) * 600 = 6000

Account balance = 192000 + 6000 = 198000

This concept of settling PnL everyday is called M2M.

Beginning of Day-2

Futures open at 1615

CV = 1615 * 600 = 969000

IM req = 193800. As you can see, the IM required for the next day has changed by 1800 

A/c bal = 198000. A/c is greater than the IM required today. The contract will continue, and 193800 will be frozen today.

End of Day-2

Futures close at 1580

Today the price fell, and you incurred a loss which is debited from your trading account.

Loss = (1580 - 1615) * 600 = -21000

A/c bal = 198000 - 21000 = 177000

Beginning of Day-3

Futures open at 1580

CV = 1580 * 600 = 948000

IM req = 189600

Here, you can see that the IM required to continue this contract is 189600, but we just have 177000. Although, at this point, our agreement will continue, this is a sign of caution that you need more money.

When this A/c balance falls below your SPAN margin, your broker would tell you to add additional funds to the trading account. This is called Margin Call. If you don't add funds, your broker is forced to square off your transaction. Now, the quote by Phillip Carret makes even more sense, right?

Currently, SEBI has allowed using shares as collateral, which means that instead of maintaining funds in the account as IM, you can keep the same value of shares as collateral. (Sweet things, easing up our lives.)

Conclusion

Looking at how aggressively brokers are using leverage to fund clients’ trading, SEBI has tweaked the margin trading rules. To understand these rules, see this video.

Just so you know, the margin requirement was increased in a phased manner from 25% to 50% and then to 75%. Now, it’s proposed to be made 100%, on which Nithin Kamath tweeted, “The dreaded day for brokers, exchanges, intraday traders, is here.” Besides, to oppose these rules, retail traders followed no-trading day on Sept 1.

After understanding the crux of the matter, please do comment on what you feel about these new rules. Is SEBI doing something right to protect the investors? Or are these extreme moves by SEBI? We would love to know what you think!