When you use margin in your trades, you are trading with a higher amount than you currently have in your account or the capital you have placed in your trade.
Leveraging trades, also knowing as using margin, is the practice of borrowing money from your bank or your broker to purchase an investment. Hearing the words “borrowing money” might give the initial impression as something too risky or akin to gambling. And while this can be true, there are reasons why it is useful to know how and why to trade on margin, and what do top investors, brokerages, and regulators think about it.
Advantages of trading on margin
When you use margin in your trades, you are trading with a higher amount than you currently have in your account or the capital you have placed in your trade.
For example, if you would like to buy 5 shares of Reliance Industries at ₹2,000 each and the price moves up to ₹2,100, you will have made a profit of (2,100-2,000)*5 i.e ₹500 for initial capital of ₹10,000.
Now, assume you are trading at a margin of 10x for the same stock at the same buying and selling prices. This means that practically for every one stock your initial capital can buy, your margin can buy 10x more shares. Simply put, your capital is now ₹1,00,000 and your profit on the same trade will be (2,100-2,000)*5*10 i.e. ₹5000.
You have made a 5% return in the first example without margin and a massive 50% return in the second example with margin. Returns like this are what makes trading on margin so exciting, especially on derivatives like futures contracts.
Disadvantages of trading on margin
However, it is important to understand that trading on margin in the cash market or futures contract is a major double-edged sword, and the losses in a trade can also be many folds the same way profits can be.
Taking the same example of buying 5 shares of Reliance Industries at ₹2,000 each and the price moves down to ₹1,900, you will have made a loss of (2,000-1,900)*5 i.e ₹500 for initial capital of ₹10,000.
Again, assume you are trading on a margin of 10x for the same stock at the same buying and selling prices. Again, your capital is now ₹1,00,000 and your loss on the same trade will be (2,000-1,900)*5*10 i.e. ₹5000.
You have cut your losses at 5% in the first example without margin but lost half your capital in the second trade with a 50% loss in the second example with margin. Trades like this are what make experienced trades wary of using too much margin, as they understand that protecting their capital is more important than chasing outlandish profits. However, it is not uncommon for beginner traders to use insane margins on their trades, only to blow up their capital and then blame the market for it.
If your losses exceed the amount inside your brokerage account, you will get a call (known as margin call) from your broker to add more collateral to your account. Failing to do so will result in your positions being automatically squared off by your broker, depriving your positions of a chance to bounce back.
Why SEBI wants to reduce your leveraging power
Indian market regulator SEBI’s new framework on peak margin reporting is aimed at preventing brokerages by providing excessive margin. Before this, brokerages could offer any amount of intra-day margin; however, now there is maximum margin limit that can be offered. This is done to reduce the intensity of speculative trades as well as ensure new traders don’t blow up their capital easily and have a short stay in the market.