Act with discretion while opting for margin trading
Fear, apprehension, panic name it and you will find it ruling investor sentiments whenever the stock market is in a corrective mood. When the decline is particularly swift or sharp, you will often find trends attributed to "margin calls".
Consider the May 2006 correction in the Indian market. One of the important factors that led to the 10 per cent fall in indices on a single day was the margin calls that brokers made to their clients.
In the rapidly falling market, since most of the positions were highly leveraged, brokers were forced to liquidate the positions in accounts which fell short of the minimum margin requirements. This selling led to a further fall in the market, creating a false sense of alarm and fear.
Margin calls, in general, can be defined as the call made by brokers to investors when the securities bought by them with borrowed money fall in value. Aggressive traders with highly leveraged positions stand to lose the most in a falling market, if they fail to maintain their minimum margin levels.
Though margin calls are a routine feature of trading, they usually make their presence felt whenever the market falls. Notwithstanding the efforts of the Securities and Exchange Board of India to put in place norms to safeguard investor interest, the correlation between a market correction and margin calls, while difficult to establish, has proved strong.
How margin trading works
To get a clear picture of how the margin trading mechanism works, consider the following example. Mr Sharma bought 1,000 shares of ITC at Rs 210 in early-May 2006, using the margin finance facility. Assuming his broker offered him 50 per cent leverage on the transaction, this would mean that Mr Sharma effectively paid only half the total transaction amount (only Rs 105,000 out of Rs 210,000) at the time of purchase. The balance, however, was borrowed from the broker/bank, which provided the margin finance facility. This would have been a win-win situation for both the parties involved had the ITC share price risen to, say, Rs 220 in a week's time. Mr Sharma would have been richer by Rs 10,000 (minus the interest that he would have to pay to the broker/bank for the borrowed money) and the bank/broker would have gained to the extent of the interest amount on the funds borrowed. Mr Sharma's net profit as a percentage of his initial investment of Rs 105,000 would have been an attractive 9.5 per cent, within the short time-frame.
But, in reality, the ITC share price did not go that high; in fact, during the May crash, it actually dropped to Rs 175. Mr Sharma would then be incurring a loss of Rs 35 per share, exposing his financer to more risk if the share price were to plummet further. It is typically during such times that the broker is forced to make margin calls to clients, asking them to either deposit more money into their account or sell some of the securities in their account to meet the margin shortfall. Now if Mr Sharma failed to make good the margin shortfall, his broker would sell his shares for the stipulated amount in consideration. Thus, apart from losing his investment, Mr Sharma would also stand to lose the opportunity to make any profit in the future, were the share prices to recover.
Now, if we look at the same transaction, without the margin trading facility, we will realise that though it trims the profits, it effectively reduces the risk when the share price slides. If Mr Sharma had not used the margin trading facility, he would not have liquidated his holdings when the market corrected.
Nevertheless, unlike the previous transaction, he would have been able to buy only 500 shares. Thus, given that margin trading can lead to inflated profits and losses, it should be opted only by traders with a high-risk appetite. Nonetheless, it has taken off well in the Indian bourses, despite the inherent risk.
Mr Sharma's case also illustrates why margin calls can magnify the decline in stock prices in a falling market. A sharp fall in stock prices usually triggers margin calls. Yet, the margin call by itself can force an investor to liquidate his position, setting off yet another bout of selling in the stock. This is how selling pressure can snowball in a declining market on account of margin calls.
Most brokers/banks offer this facility to improve their business and service existing clients. The service is offered at an interest rate in the 11-16 per cent per annum range (rates may vary). However, it may be interesting to note that a broker may liquidate the securities of the client if the latter fails to meet the margin call requirements or to deposit the cheque for the required amount the next day (a day after the margin call is made). The broker can also liquidate the positions if the cheque deposited by the client gets dishonoured.
However, if the client's deposit in the margin account (after adjustment for mark to market losses) falls to 30 per cent or less of the latest market value of the securities, in the time period between the margin call and the receipt of the payment from the client, the broker can liquidate the positions to recover the sum in consideration.
Margin trading is an effective leveraging technique provided the markets are in your favour. However, being a high-risk service, it suitable only for traders who transact in either large volumes or amounts.
It is to be noted that margin-trading facility is available only for select stocks. Therefore, before you opt for it, make sure you are aware of the stocks that are covered under the facility. For investors who saw the devastating impact of margin trading during the May crash might agree with Kin Hubbard, an American humorist, who said that the safest way to double your money is to fold it over once and put it in your pocket.
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