What are Risks Associated with Margin Trading?

Where there is a good and profitable trade, there is also an element of risk. That is how markets are structured. Here we look at margin trading risk or the risk of margin trading. Let us spend a moment just brushing up the concept of margin trading first. Margin trading is a frequently used term in stock markets and as the name suggests you can do margin buy or you can also do margin sell. Buying on margin, as the name suggests, entails paying just part of the amount that is payable for the purchase of shares.

Broadly, margin trading can take 10 different forms

Here are some unique types of margin trading that you either entail funding the margin of using proxies to fund margins.

1. Taking an intraday buy position
2. Taking an intraday sell position
3. Buying stocks on margin for delivery
4. Selling stocks on margin when not in demat account
5. Buying futures instead of in cash for leverage
6. Selling futures instead of delivery selling to leverage falling prices
7. Buying call options to play a bullish view on a stock
8. Selling put options to play a moderately bullish view on a stock
9. Buying put options to play a bearish view on a stock
10. Selling call options to play a moderately bearish view on a stock

As you can see above, all of the above may not strictly classify as margin trading but effectively they are all some form of margin trading in that you take a position in the market by just paying a margin or part of the whole amount. Broadly margin trading takes various forms. You can do buying on margin via intraday trading, actually funded margin buying or you can also leverage futures to create a proxy of buying on margin. The key advantage of buying on margin is that you can take a much larger position that what your current financial capacity affords. Let us look at Buying on margin and also margin sell in greater detail as we go along.

Let us assume that you want to buy 10,000 shares of State Bank of India. If you were to buy 10,000 shares of SBI in the equity cash market, it will cost you Rs.33 lakh to take delivery of that stock assuming the approximate current market price of Rs.330 per share. In case, you have the requisite funds in your trading account, it is well and good, but that is rarely the case. The other option for you is to buy on margin. Obviously, when you buy or sell a stock by just paying part of the money, there is a huge risk to it. Slick salesmen would tell you that margin trading magnifies your profits but what they don’t tell you is that it also magnifies your losses. It runs the risk of wiping your capital and all the risks of margin trading actually stem from this singular risk of losses getting magnified. Let us look at risks of margin trading in greater detail.

Risk Involved in Margin Trading

Having conceptually looked at risk of margin trading, let us focus a little more on leverage risk since that is the key to margin trading. Margin trading risk essentially stems from leverage risk, which is the risk of quasi borrowing magnifying your losses beyond a point. Margin trading risk emanates from leverage risk? What exactly is leverage risk? Now, leverage risk arises because margin trading buying encourages you take market positions of a size you cannot normally afford. For example, if you can buy 200 shares and you buy another 800 shares on margin, then the leverage risk to your capital is 5X in every unfavourable rupee move. Of course, if the price is favourable then profits are also 5X, but that is not relevant to risk management. Let us now look at some key risks involved in margin trading.

• The biggest and most important Margin trading risk is the risk of leverage. The risk is that margin trading might induce you to take positions larger than you can afford. In such cases, if your position is not properly managed, it could backfire and the losses could mount so rapidly that the entire trading capital can get wiped out in no time. Leverage risk is at the core of margin trading and all other risk we shall discuss here stem from leverage risk.
• The second risk is the risk of not putting stop loss or the indiscipline risk. In any margin funding position, stop loss is a must. You cannot get imagine getting into a position and then wait for an opportune moment to put the stop loss. The stop loss has to be part of the order and at a level you can afford to lose. Above all, you have to maintain the discipline of stop loss and not average positions because you feel like it.
• An extension of the stop loss risk is the profit target risk. What is the use if the stock you bought is up 25% in 4 days and in the next 1 week gives up all the gains. In margin trading booked profits is a lot more material than book profits and if you don’t keep the profit booking discipline, you run a huge risk in margin trading. The moral of the story is to keep churning your capital and try to reduce the turnaround time for your positions. That is your best bet against market volatility as interest cost also does not add up.
• You may not own the funds but you are the owner of the margin funding position and not the broker. The biggest risk is not monitoring your margin funded position close enough. You may not get a good price but most often you need to do a trade-off between a small loss and big loss or a trade-off between a small profit and a big profit. Remember, if something is too good to be true, then it is probably not true.
• Remember the volatile stock risk in margin trading. In margin funded positions, make it a point to always avoid stocks that are too volatile or that are too static. Either ways you run the risk of losing money. The risk becomes a lot more pronounced in volatile stocks because they also run overnight risk and the risk of SEBI deciding to impose special margins or additional special margins on such stocks.
• A major risk in margin trading is not understanding the breakeven and profit conditions before getting into the margin funded position. Make it a point to calculate the break-even cost of your position after considering your cost of funding, which is either the real cost or the opportunity cost of capital deployed. Also consider other costs to the margin funding like administrative charge, DP charges and statutory costs; which are over and above the interest cost.
• Finally, an important risk is the risk of not being able to meet a margin call. This risk is the most common when you opt to do margin trading via futures or short options. In such cases, you are liable to pay initial margins for SPAN plus ELM and also daily MTM or mark to market margins. These MTM margins will go against you if the price move is unfavourable. In such cases, the broker would make a margin call if the margin balance falls below the maintenance margin level. If you are unable to pay margins, then the position is liquidated at market resulting in losses quite often.

How does Margin Trading Work?

Here is what margin trading or buying on margin entails. Let us assume that you want to buy 10,000 shares of State Bank of India. If you buy 10,000 shares of SBI in the equity market, it would cost nearly Rs.33 lakh to take delivery of that stock assuming the approximate current market price of Rs.330 per share. In case, you have the requisite funds in your trading account, then there is no problem. Alternatively, you can take a margin position as intraday, or through futures or via margin funding by the broker or any NBFC.

What does margin buy and margin sell imply and what are the risks associated with margin trading? There are broadly two kinds of margin trading that you need to be familiar with. Remember, as we had said earlier, you can either pay a part of the sum and get leverage or actually borrow the balance amount by paying interest. The latter is the route if you want to enjoy the perks of stock ownership like dividends, voting rights etc.

Who should do Margin Trading?

Margin trading is a slightly high risk game as it entails magnifying your profits and also potentially magnifying your losses. Hence margin trading should only be taken up if you are confident of managing the risk with the discipline of stop losses, profit targets, call risk management etc.