What is Margin Money?

Have you ever looked at the fundamentals of a company and felt bullish on its stock, had an idea that it was going to do well, but you fell short on funds and wished you had more money to invest in it. Meet Rohan, he has saved up Rs.50,000 in his trading account. After weeks of research, he finds a company to invest in, the stock is trading at Rs.500, and he feels it’s a golden opportunity. With his money, he can only buy 100 shares, but he wishes he had more capital to buy more stocks due to strong company fundamentals and rising growth. This is a common feeling for many of us.

Imagine you come across a facility which gives you the opportunity to purchase more shares and earn more profit on those shares. This is where a special facility offered by stockbrokers comes into the picture, known as margin trading.

What is Margin Money? 

It is the money you borrow from your stockbroker over and above the money you have to buy shares. Think of it as a loan, the shares you buy with this borrowed money are kept as security with the broker, much like a bank keeps your house papers as security when you take a home loan. 

It is used to buy more shares than you could afford with just your own cash, a practice known as “buying on margin”. This facility, often called the Margin Trading Facility (MTF) in India, allows Rohan to potentially turn his Rs.50,000 investment into a much larger one, thereby borrowing additional funds from his broker so he can have more shares that have high potential of giving large profits.   

Read Also: What is Margin Funding?

How it Works

1. Margin Account: To start with it, first you need to have a special account called a margin account. This is different from a regular “cash account” where you only trade with the money you have deposited. When you open a margin account, you’ll need to agree to certain terms and conditions set by your broker and regulatory bodies.

2. Margin: It means depositing your own cash or eligible securities into a margin account as collateral for the loan taken from your broker.

3. Broker’s Loan: Your broker then lends you the remaining amount needed to complete the purchase of the securities. One has to pay interest on this borrowed money, just like any other loan.

4. Leverage: Leverage means you amplify your potential gains if the investment performs well. It’s crucial to understand that it also amplifies your potential risks if the strategy doesn’t work.

Components of Margin Money 

1. Initial Margin

The initial margin is the percentage of the total share value you must pay from your own funds before borrowing from your broker.

If you want to buy shares worth Rs.1,00,000, your broker has prescribed an initial margin requirement of say 40% (varies from broker to broker). This prescribed percentage which is set by the broker becomes the initial margin. The broker while deciding the initial margin has to follow the minimum rules set by the market regulator, SEBI, to prevent people from taking too much risk.   

So, with just Rs.40,000 of his own, one can now control shares worth Rs.1,00,000. The initial margin is what decides your borrowing power, or leverage. A lower initial margin means you can borrow more.   

2. Maintenance Margin

Once you’ve bought the shares, the value of these shares will go up and down every day. The broker, who has lent Rs.60,000, needs a safety net in case the stock price falls. This safety net is called the Maintenance Margin.

The maintenance margin is the minimum value of your own money (your equity) that you must always have in your margin account. You might notice that the maintenance margin percentage is usually lower than the initial margin percentage (40%). This gap acts like a shock absorber, giving your investment some room to handle small, everyday market movements without causing immediate panic.   

Let’s look at Rohan’s account right after buying the shares, current value of stocks is Rs.1,00,000, loan from broker is Rs.60,000, Rohan’s equity of Rs.40,000 and the Maintenance margin required 25% of Rs.1,00,000 = Rs.25,000

3. Margin Call

The stock Rohan was so optimistic about, now starts to fall. The total value of his investment drops from Rs.1,00,000 to Rs.75,000. This drop can trigger a Margin Call. A margin call is a demand from your broker to add more money to your account because your equity has fallen below the safety net level, the maintenance margin. The broker will call, email, or send an SMS to Rohan, asking him to deposit the shortfall.   

If he fails to meet the margin call, the broker can sell his shares without permission to recover the loan, this is called forced liquidation.   

Read Also: Margin Pledge: Meaning, Risks, And Benefits

Advantages of Margin Money

1. Higher Profits: It offers the potential for much higher returns on your capital, but remember these things can go negatively as well.
2. Increased Buying Capacity: You can buy more stocks than you can buy with your own funds.
3. Flexibility and Speed: It allows you to act on market opportunities quickly without needing to have all the funds upfront.
4. Portfolio Diversification: You can spread your investment across several different stocks to help manage risk.  

Disadvantages of Margin Money

1. High Loss Potential : The potential for higher losses is just as real as for higher profits, and you can lose more than you initially invested.
2. Interest Costs : The money you borrow is a loan, and you must pay interest on it, which reduces your profits or increases your losses.
3. Risk of Forced Liquidation : If you get a margin call and can’t add more funds, your broker can sell your stocks to recover their loan.
4. Limited Availability : Not all securities are allowed on margin. Usually only liquid, high-volume stocks can be bought. 

Read Also: What is Stock Margin?

Conclusion

Margin trading is a powerful tool, but it does not guarantee profits. It gives you the power to amplify your gains, but comes with the very real and equal risk of amplifying your losses.   

Margin trading is generally considered more suitable for experienced traders who have solid risk management strategies, and can afford to lose the money they are trading with. It is often used for short-term trading and is not recommended for beginners or for long-term investing, mainly because the interest costs add up over time.   

The most important investment you can make is in your own knowledge. Before thinking about using margin, it is crucial to educate yourself. Platforms like Pocketful offer free, in-depth lessons on financial markets.   

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