• Margin Trading

    Margin Trading enables an investor or trader to borrow money from the brokerage house to buy shares. Here the bought shares are kept as collateral with the brokerage company.

    Margin trading allows the traders to trade on shares with limited money. There are two types of margin requirements needed to do the margin trading. One is initial margin requirement required to initiate the trading and second is maintenance margin requirement required to hold the trading.

    Initial margin requirement denotes the initial percentage of money to be provided by the trader with the rest provided by the brokerage firm to initiate the trading. Maintenance margin requirement specifies the trader’s required equity position or value to continue holding the shares in the account. If the margin requirement is crossed the maintenance limit, the trader has to deposit more money or sell some shares to bring the account back to its maintenance margin requirement.

    Example

    • Suppose the initial margin requirement is 50% and the maintenance requirement is 25%.
    • Suppose the current share price of a company X is USD 12 and one trader is planning to buy 1000 shares at margin.
    • Total trading value will be USD 12000, in which the trader will pay only 50% of the total trading value which is USD 6000 to buy 1000 shares.
    • Let us see how the maintenance margin requirement works. 25% Maintenance margin means the trader is expected to keep 25% more money than his exposure in the share to hold the position. As the initial margin requirement is 50%, the exposure of the trader in the share is USD 6 per share.
    • If the price is changed to x then the maintenance margin is required will be x*0.25 = x/4, which has to be less than the trader’s profit to hold the position.
    • Once the share price drops to a limit value the maintenance margin will be used completely. At that time, the maintenance margin will be same as the profit of the trader. Up to that limit value, the maintenance margin can be maintained.

    Mathematically when the maintenance margin is used completely,

                Profit of the trader at market price x = Maintenance margin

    Or, (X-6) = X (0.25)

                            Or, X (1-0.25) = 12(1-0.5)

                            Or, X (1 – Maintenance margin) = 12 (1 – Initial Margin)

                            Or, X = 12 (1 – Initial Margin) / (1 – Maintenance margin)

                            Or, X = USD 8

    • The maintenance margin requirement can hold for share value of Rs. 8. Below which there will be a margin call and the trader has to deposit more money.

    Margin Trading increase the profit and rate of return as lower initial amount is used to do the trading. At the same time it increases risk as well because of higher exposure with the same amount of money.

    If the share price increases by 25% to USD 15 then the profit will be (15-12) = USD 3 per share or USD 3000 as a whole. In this case the rate of return will be (3000/6000)*100% = 50% when the share price itself was increased by only 25%. This is how it increases the profit.

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