Who are Margin Traders?

Margin traders are speculators looking to make a quick profit from movements in prices by leveraging beyond what their current financial capacity permits. Margin traders ensure that they don’t miss out on any trading opportunity due to the paucity of funds. What the Margin traders do is use the margin account as a leverage machine to enhance the size of trades where conviction is high.

Margin traders are not only on the long side but on the short side also, but we will not get into that for now. Let us understand Margin trader's meaning and how do these Margin traders operate. Here is a detailed look at what the Margin trader's meaning is and the role they play in the markets.

Understanding Margin Traders

You can look at these margin traders as speculators who play the equivalent of the derivatives leverage game in the equity market. This facility is very useful for margin traders when they don’t want to pay the full amount and prefer to get it funded or just because the margin traders do not have the resources at this point. In margin trading, these margin traders only pay a fraction of the value of the outstanding position. This is called margin trading and results in a high leverage factor with a small deposit. As a result, margin traders can punch above their weight by taking larger positions than they can normally afford.

You can therefore look at margin traders as speculators who use the leverage facility in the cash market too. They treat the margin trading account as a trading account overdraft facility to leverage opportunities.

Types of Margin Trading Strategies

What are the strategies that margin traders deploy when doing margin trading? Here is a quick dekko at the various strategies that margin traders can adopt.

1. You must be clear about where you want to use the margin account. Ideally, margin traders prefer to stick to predictable assets, show a reaction to a stimulus, and also allow quick churning of capital. The purpose is very important. A margin account seeking long-term growth would be the most appropriate for the active trader. However, you would not want a margin account for your retirement plan as it would become too risky.

2. Selecting the asset class is one thing, the more important part is selecting the right stock. That is important in a margin purchase, where a wrong guess can cost much more. Ideally, margin traders must focus on companies with strong fundamentals and in growth industries with an established track record of long-term growth. A margin account is not suited for volatile hot stocks.

3. The golden rule in margin trading is to keep the period as short as possible. Today many brokers in India allow you to carry the margin position for longer. But that comes with a cost and the longer you stay, the more your cost builds up and the more it gives you ulcers and sleepless nights. The idea of keeping it short is that you move in and out of the position quickly, so that saves you macro risks and keeps capital in motion.

4. It is always best to avoid margin calls, so ensure that the margin account is adequately funded and you always hold more than the maintenance margin. Being forced to sell is never a good idea as it can lead to sub-optimal decisions. Always calculate upfront your minimum maintenance requirement at approximately 30% of the value of holdings.

5. Fine-tune your exit process and know when to get out of a margin trading position. This applies to both the winning and losing trades. If you purchased stock on a margin that has had a good run, don't get greedy. If something is too good to be true, it is probably not true. Don’t take chances. Set a target price and stop loss and maintain discipline.

6. Like you test drive a car before buying, do a test drive on margin trading too. Do live margin trades but do it in just a couple of stocks and get comfortable. That way, you can experience the benefits, risks, and costs firsthand.

Margin Trading Example

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
The 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.