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Tread with caution

While margin trading may be a good way of seizing perceived opportunities, it comes with its own pitfalls, writes Sanjeev Sinha.

business Updated: Apr 02, 2008 22:17 IST
Sanjeev Sinha

If you are keen on seizing perceived opportunities in the stock market without having enough resources, then margin trading may be one option for you. Although not a recommended way, margin trading is a leveraging mechanism, which enables investors to take exposure in the market over and above what is possible with their own resources.

Market regulator Sebi, from time to time, has been prescribing eligibility conditions and procedural details for allowing this facility. Currently corporate brokers with a net worth of at least Rs 3 crore are eligible for providing margin-trading facilities to their clients.

However, before providing this facility, the member and the client are mandated to sign an agreement for this purpose in a format specified by The Securities and Exchange Bureau of India (Sebi).

It has also been specified that the client shall not avail the facility from more than one broker at any time.

The agreement provides the terms of margin trading, the extent of margin and other details. The initial margin has been prescribed as 50 per cent and the maintenance margin as 40 per cent. “For providing this facility, a broker may use his own funds or borrow from scheduled commercial banks or NBFCs regulated by the RBI. However, the broker is not allowed to borrow funds from any other source,” informs Ashish Kapur, CEO, Invest Shoppe.

Also, the ‘total exposure’ of the broker towards the margin trading facility should not exceed the borrowed funds and 50 per cent of his ‘net worth’.

The broker also has to ensure that the exposure to a single client does not exceed 10 per cent of his ‘total exposure.’

One significant point to note is that the facility of margin trading is available for Group 1 securities and those securities, which are offered in the IPOs. “The list of scrips which are covered by this facility for NSE and BSE are limited (about 600). Any scrip which is not included in the said list shall not be funded,” says Trivikram Kamath, senior V-P and head of operations, finance and technology, Kotak Securities.

Here’s an example to get a clear picture of how the mechanism works: Suppose Mr X buys 1,000 shares of ABC Co at Rs 210, using the margin finance facility. Assuming his broker offers him 50 per cent leverage on the transaction, Mr X effectively pays only half the total transaction amount (Rs 105,000 out of Rs 210,000) at the time of purchase. The balance is borrowed from the broker/bank.

Now if the share price rises to, say, Rs 220 in a week’s time, Mr X would be richer by Rs 10,000 and the bank/broker would gain to the extent of the interest amount on the funds borrowed. However, if the share price drops to Rs 175, Mr X would 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 X fails 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 X would also stand to lose the opportunity to make any profit in the future, were the share prices to recover.

Thus while margin trading allows you to take a higher exposure in scrips that you expect to rise, it could also amplify losses to the same degree. “It should, therefore, be opted only by traders with a high-risk appetite,” advises Kapur.