This strategy lets you take bigger positions—But is it worth it?

Are you a trader looking to place a trade but do not have enough capital to do so? You are not alone. In recent years, margin requirements for trading have increased, and that means you need more money to place a trade. One strategy that can prove useful here is margin trading. What is margin trading, and is it worth using? Let’s find out.

What is margin trading?

​Margin trading allows you to purchase a larger position than your available funds permit by borrowing the remaining amount from a broker. This strategy amplifies both potential gains and losses. ​

Suppose you have Rs 20,000 and wish to buy shares worth Rs 50,000. With a margin requirement of 20 per cent, you infuse Rs 10,000 (20 per cent of Rs 50,000) as capital, and the broker lends you the remaining R 40,000.

If the share price increases, your profits are magnified. However, if it decreases, losses are also amplified, and you may need to provide additional funds to maintain the required margin.

Potential benefits of margin trading

By using borrowed funds, traders can amplify their market exposure and trading options - a core feature of margin trading. This strategy presents several potential benefits:​

1. Increased purchasing power and returns

​Margin Trading Facility (MTF) enables traders to trade more shares than their available funds would allow by borrowing the remaining amount from their broker.

This approach can magnify potential profits if the market moves favourably. For instance, trading Rs 1,00,000 with 4X leverage allows control over Rs 4,00,000 worth of securities.

A 10 per cent price increase could yield a Rs 40,000 profit, quadrupling the return compared to an unleveraged trade. However, it's crucial to remember that while gains can be amplified, losses can be as well.​

2. Portfolio diversification

​Access to additional capital enables traders to acquire a broader range of assets, such as stocks, bonds, and commodities, without liquidating existing positions.

This approach facilitates the construction of a diversified portfolio, potentially reducing overall risk by spreading trades across various asset classes.

For instance, a trader can simultaneously increase exposure to multiple uncorrelated assets, maintaining diversification benefits while aiming for enhanced profits.

3. Capitalising on market opportunities

Traders can seize timely market opportunities by using the margin facility to access additional capital, enabling them to act quickly on favourable market conditions without waiting to accumulate sufficient funds.

For instance, identifying a promising stock poised for growth but lacking the necessary capital, a trader can utilise margin to establish a position immediately, potentially leading to higher profits.

This approach allows for prompt responses to market movements, enhancing the potential to capitalise on short-term opportunities.

Risks and downsides of margin trading

While the margin trading strategy can enhance buying power, it carries several significant risks:

1. The risk of magnified losses and margin call

Margin trading offers leverage and that means that even minor market fluctuations can lead to disproportionately large profits or losses.

For instance, if the market moves unfavourably, traders might lose more than their initial capital, exacerbating financial exposure.

Also, when the value of securities purchased on margin declines, traders have to maintain a minimum balance known as initial margin. Failure to meet this requirement can trigger a margin call, necessitating the deposit of additional funds or the liquidation of an existing position.

If the margin call is unmet, brokers have the authority to liquidate securities, potentially at unfavourable prices, to recover the borrowed funds.

2. Interest costs

​In margin trading, traders borrow funds from brokers to purchase securities, incurring interest charges on the borrowed amount.

In India, these interest rates vary by broker, typically ranging from 5 per cent to 15 per cent annually. For example, borrowing Rs 1,00,000 at a 10 per cent annual rate results in approximately Rs 27.40 in daily interest. These costs accumulate over time, potentially reducing the overall profit.

3.  Market volatility

The Indian stock market can be highly volatile, influenced by economic indicators, political events, and global market trends.

This leads to rapid and significant price changes, increasing the risk of a trade turning favourable, and with that comes the need to either fuel in more capital to avoid a margin call or face losses.

Is margin trading worth it?

​Margin trading can increase both potential gains and losses by allowing traders to control larger positions with borrowed funds. While it offers increased purchasing power, it also comes with risks, including losses and interest costs.

To assess the viability of margin trading, tools like an MTF calculator can be used. This tool helps estimate the required margin, interest charges, and potential returns, enabling traders to make informed decisions.

Ultimately, the worth of margin trading depends on individual risk tolerance and market conditions.​

Conclusion

​Margin trading allows traders to borrow funds to take up large market positions, potentially increasing both gains and losses. While it offers the opportunity for attractive profit levels, it also exposes traders to significant risks, including the possibility of losing more than the initial capital and facing margin calls. Careful consideration of one's risk tolerance and financial situation is essential before engaging in margin trading.​