When an investor borrows money from his broker to buy stocks, the process is called margin trading. Margin is a way of increasing your purchasing power for investments. Buying on margin means that you take a loan from your broker to increase the amount of funds you have at your disposal to invest. The loan comes with its own costs in the form of interest and there are limitations on how you use the loaned funds. If you wish to go for trade in margin then you need to have a margin account. Once your margin account gets activated, then you can borrow up to 50% of the purchase price of the stock.
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For Example : You have Rs 5000 to invest and are interested in the shares of Sport Sun Shoes, selling at Rs 50 per share. If you use only your own funds to make the investment, you can buy 100 shares of the company. But you decide to get your broker to lend you another Rs 5000. You can now buy 200 shares with an initial investment of just Rs 5000 from your side. Let’s say the price of the Sports Sun shares goes up to Rs 100. If you had invested only your own Rs 5000, your investment would now be worth 100 shares x Rs 100 = Rs 10,000. Your return on investment in this case will be 100%.
But as you had bought the shares on margin, adding the broker’s Rs 5000 to your own funds, your investment is now worth 200 shares x Rs 100 = Rs 20,000. You have doubled your investment’s value with an outlay of the same Rs 5000 from your side. Of course, you will still have to pay back the Rs 5000 plus interest and other applicable charges on the margin, but even after deducting that amount, you will be left with much more profit than you would have if you had not used margin. Your return on investment in this case will be 200%.
This example shows how using margin at the right time and with the right investments can multiply the gains you stand to get with your investment. However, the most important thing to understand about margin trading is that it not only amplifies your gains, but also your losses. In the same example, if the stock price had fallen, you would lose much more when you use margin trading. This is the reason why margin trading is considered quite risky (more on this in the section on risks).
Below are certain terms that would make the concept more clear.
Initial margin: The proportion of total purchase price an investor is supposed to deposit for opening a margin account is referred as its initial margin and is generally 50% of the total value.
Maintenance margin: In order to keep the margin account open for doing margin trading, it is necessary to maintain minimum cash or marginable securities which is called the maintenance margin. This is just to prevent an investor from incurring a level of debt that he would not be able to repay.
Margin call: If your account falls below the maintenance margin, your broker will make a margin call to ask you to deposit more cash or securities into your account. If case you fail to meet the margin call, your broker will sell your securities so to make up for the stipulated maintenance requirement.