The toughest of times for any stock market investor is when the markets see a free fall and you get a call from your broker to put up additional “margin.”
When this happens, though you might continue to be optimistic on the fundamentals of the stock, you may be forced to liquidate it, as “your maintenance margin has gone below the permissible limit.” Retail investors who can’t provide cash margins to meet the margin call end up with a heavy loss. Investors who avail margin funding from their broker often fail to see that they are actually “leveraging” their investments. Here’s what you need to know about margin trading.
A margin trading agreement allows the trader to borrow up to 50 per cent of the total money required for a stock purchase from the broker, at a pre-agreed rate of interest. The client stands liable to pay the interest on margin funding, which usually ranges between 16 and 20 per cent per annum, till the time the borrowed amount remains outstanding.
Do note that only securities that come under SEBI’s ‘Group 1’ are eligible for margin funding. These would generally be scrips that display low volatility and high liquidity.
Also, the borrower is expected to maintain the margin provided by him at 40 per cent level. A breach in this level at times of market slump would trigger margin calls requiring the clients to top-up their margin accounts by cash payments. At any time when the value of the equity in the margin account falls to 30 per cent or below it, the stock could be sold by the broker for securing his position after intimating the client.
Suppose X wants to buy stock worth Rs 5,000. His stock-broker agrees to fund his purchase by paying 50 per cent of the intended purchase value. X signs the margin funding agreement. He puts in his initial margin Rs 2,500 and the broker puts in the remaining Rs 2,500 and the stock is bought.
Situation 1: The value of the stock bought goes down to Rs 4,000
Maintenance margin required = 40 per cent of Rs 4,000 = Rs 1,600
Value of the equity in the margin account = Rs 4,000- Rs 2,500 (loan from the broker) = Rs 1,500. So here X would get a margin call to pay Rs 100 to top-up his account.
Situation 2: The value of the stock bought goes down to Rs 3,000.
Maintenance margin required = 40 per cent of Rs 3,000 = Rs 1,200
Value of the equity in the margin account = Rs 3,000-Rs 2,500 = Rs 500 (this is 16.67 per cent of the equity’s value in account). X’s broker stands powered to sell the stock and secure his position.
Many traders don’t even read the terms of the Margin trading agreement they sign. Claiming lack of awareness about the terms of the deed at a later stage indicates only the individual’s negligence. The following are the key terms of a margin trading agreement:
The borrower agrees to make good the deficiency in margin account.
On the client’s failing to meet the margin requirement, the broker may immediately sell the shares.
The client authorises retention of shares with the broker till the time he repays the amount due completely.
The broker is free to modify the initial and maintenance margin requirements.
The client pledges the security bought under the arrangement with the broker as security for repayment of the due.
Any communication by the parties involved should be in writing and duly served.
On the receipt of sale proceeds from the stock exchange, the broker may deduct the amounts due to him and give only the net credit to the client.
On the agreement being signed, the broker opens a margin trading account in the name of the client. Until the broker’s dues are settled completely the securities bought under the said arrangement remain in the margin account after which they would move into the client’s Demat account.
Using margin funding to transact in stocks is not for novices. As availing of margin funding involves “borrowing” money where you have to shell out an interest cost, you have to make sure your eventual returns make up for it. Highly volatile markets such as the present one make it quite risky to avail of margin funding as margin calls may be triggered very quickly. If the client can’t make an immediate cash settlement to honour his broker’s margin call, his stock holding would be sold by the broker for whatever value that could be realised from the market.
Stocks are not accepted against margin requirements — both initial and maintenance. Even if you top-up your account on every margin call, remember that every other day that you carry forward your loan, you are also shelling out stiff interest costs. The interest will keep accruing and increase your debt burden till the time you repay the loan completely. Borrowing at interest rates of over 16 per cent for an investment that has no assured returns does not appear prudent, when market direction is quite difficult to predict.
Margin trading is for people with a high risk appetite, who also have surplus cash to back them up during a stock market meltdown. The high borrowing costs involved in such investments may make it an unsuitable tool for long-term investors.
Rajalakshmi Sivam
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