Margin Trading Versus Short Selling

Last Updated: 1 Sep 2022

It is quite normal to get generally confused between short selling vs margin trading. While both are similar in some ways, they are also vastly different. Here we look at the difference between margin trading and short selling. We look at the short-selling vs margin trading debate in greater detail here.

What you need to understand in the margin trading vs short selling debate is that both try to leverage existing resources to enhance returns. However, the risks and returns may be different. That is why it is better to understand this margin trading vs short selling debate in greater detail. Let us look in this section at the difference between margin trading and short selling.

Margin Trading Vs. Short Selling

Let us begin this margin trading vs short selling debate by understanding that the stock market offers intraday traders different methods to gain leverage and maximize ROI or the return on their investment. Among the various methods available to investors and traders, margin trading and short selling are commonly utilized by experienced traders. The idea here is to gain an edge in equity trading. It would be instructive for you to understand how margin trading vs short selling will give you mileage. After all, the big challenge here is to get more bang for the buck and enhance ROI.

To get a better hang of the margin trading vs short selling debate, we will start by defining what margin trading and short selling mean and then we shall look in detail at the difference between margin trading and short selling.

So, what exactly is margin trading? The facility of margin trading or MTF as it is popularly called, allows you to invest more than the money you have available in your trading account with the SEBI registered broker. It is called margin trading financing or margin funding because you activate a margin account with the broker and then the broker allows you to buy more than you can afford and only charges you interest if there is a net debit on your trading account, not otherwise. Typically, if you have a margin account with the broker, you will be permitted to carry out margin trading and take a bigger position on your trades by paying just a fraction of the cost of the shares. Of course, you need to ensure that your margin account is always kept replenished with basic maintenance margin money.

The beauty of margin funding is that you can use it to leverage positions in the cash market, futures market, or options market. The principle more or less remains the same.

Margin trading 101 with a live instance

How exactly does margin trading work in practice? Let us say you want to buy 500 shares of Adani Ports SEZ at a price of Rs.700, costing you Rs.350,000 in all. Now assume that in your margin account, you just have Rs.140,000 and you don’t have additional funds to infuse. Can you still take the equity position? Yes, you can if you opt for the margin trading facility or MTF. In the MTF, you put your margin of Rs.140,000 and the broker will fund the balance of Rs.210,000 so that you can go ahead and buy 500 shares of Adani Ports SEZ. The amount of Rs.210,000 is your margin-funded position on which you have to pay interest.

If the price of the stock goes up on T+2 days, then there is no problem. You can deduct the cost of the transaction and the interest from the sale amount and close out the position. Here is how the calculation will look if the price of Adani Ports has moved up to Rs.740 at the end of 2 days. Let us assume interest cost is 15% annualized applied for base 7 days.

Cost of buying Adani Ports SEZ – Rs.350,000
Brokerage and statutory costs (0.55%) – Rs.1,925
Total cost of the position – Rs.351,925

Sale price of Adani Ports on T+2 – Rs.370,000
Brokerage and statutory costs (0.55%) – Rs.2,035
Interest on Margin funded portion – Rs.604
(interest = 210,000 x 0.15 x 7/365)
Total value realized on sale – Rs.367,361

Net Profit on the MFT transaction is Rs.15,436

That looks like a good deal because, on his base margin of Rs.140,000, he has earned a return of more than 10% in a sharp period. But prices don’t all move your way. At times, the price may go down, so you have to put up the money in the margin account for bridging the gap.

Now let us turn to understand how short selling works?

How exactly does short-selling work?

Short selling is a method in which you are allowed to sell shares that you do not own in your Demat account. This can again be done using the margin trading facility offered by the broker and you are free to do this once your MTF facility is activated. Since you don’t have these shares in your Demat account, you can sell these shares in the margin account and make a profit when the price goes down. You can understand short selling in a few very basic steps as under.

1. In the first step, you borrow shares from your broker, who sells them on your behalf
2. The broker credits the proceeds of the sale to your trading account on T+2 day
3. Once share price starts coming down, you can instruct the broker to buy back shares and close the position
4. The proceeds from the sale will be used to fund the purchase of shares in the MTF account
5. The differential profit, after adjusting for brokerage, statutory charges, and interest on margin is credited to the trading account
6. If you are long on margin fund, you are short in short selling. In margin funding, you bet on the price rising while in short selling your bet on the price falling. In both cases, you run the risk of unfavorable price movements. Be conscious of that risk.

Benefits of Margin Trading

Some of the key benefits of pledging shares as collateral can be summarized as under.

• It offers higher leverage at almost zero cost and you don’t miss out on trading opportunities due to a shortage of funds.
• There is no cost for marking your stock as collateral so any short-term funding gaps can be arranged through this method at zero cost.
• You can enhance your buying power and grab trading opportunities by simply leveraging your stock holdings and not worrying about arranging funds.

A big advantage is that even pledged, your shares can still be sold.

There are three major benefits of short selling.

• Short selling allows you to speculate on stocks where you expect the price to fall, even if you don’t own the stock
• You can use short selling to hedge the long position in similar stocks
• Generally, short selling tends to be more efficient from a tax perspective

Frequently Asked Questions

What is the penalty for short selling?

Investors not able to provide the securities at the time of settlement, are obligated to pay the penalty charges to the clearing member. The penal charge is levied on the amount in default as per the bye-laws relating to failure to meet obligations by any clearing member. Currently, clearing member charges 0.07 per cent of the default amount per day for overnight settlement shortage of value more than Rs.5 lakhs, security deposit shortage and shortage of capital cushion.

A penalty of 0.5% of the order value is levied in case of short reporting by trading/clearing member for short collection of less than Rs.1 lakh and less than 10% of applicable margin. However, a higher penalty of 1% of order value is applicable on short reporting equal to Rs.1 lakh or equal to 10% of applicable margin and above.

What happens if short seller Cannot cover?

It goes into auction and the auction losses have to be borne by the short seller. That is the risk in short selling.

Which is safer margin trading or short selling?

Short selling risks have to be managed closely just like margin trading. Both are risky and you need to manage risks in both cases.