Why do stockbrokers levy a margin
Now that you understand what margin in the share market is, let us examine the logic behind why stockbrokers levy a margin. The margin money you deposit with your broker to enter into a large trade acts as a form of collateral to cover any potential losses that may occur while the position is open.
For example, assume that the value of the securities you purchase falls after you enter into a trade. In such a situation, the broker will suffer losses since they may not be able to recover the dues in full even after liquidating the pledged securities. Here is where the margin you initially deposited will help cover the losses that the broker suffers due to the decline in the value of the securities pledged.
An example of margin in the stock market
Margin trading allows you to leverage your investment by borrowing money from your broker. For example, if you deposit Rs 10,000 in your margin account and your broker offers a 2:1 margin, you can potentially buy up to Rs 30,000 worth of securities. However, you'll only own Rs 10,000 worth of shares, and the remaining Rs 20,000 is borrowed from the broker.
It's important to note that the buying power in your margin account fluctuates based on the market value of the securities you hold. As the value of your securities changes, so does your buying power.
Remember, margin trading can amplify both profits and losses. It's crucial to understand the risks involved and use margin wisely.
Who is eligible to trade on a margin?
Stockbrokers with the margin trading facility typically offer it to all traders and investors who apply for it. There are generally no eligibility criteria that you need to satisfy to be able to trade with margin money.
However, the amount of leverage you are eligible for may vary depending on the stockbroker and the security you wish to purchase.
What are the types of margins?
Margin is often categorised into three types. Let us explore the different types of margins in detail.
- Initial margin
The margin money you initially deposit with the stockbroker to enter into a trade is known as the initial margin.
- Maintenance margin
If the value of the securities you purchase via margin declines below a certain level, your stockbroker may ask you to deposit additional funds to keep your position open. This additional money is known as the maintenance margin.
- Variation margin
Also known as the Mark-to-Market (MTM) margin, the variation margin is the amount of money that is added or subtracted from your trading account at the end of a trading day to reflect the changes in the value of your positions. For instance, margin money is subtracted from your account if the value of securities goes down and vice versa.
Advantages and disadvantages of Margin borrowing
Advantages
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Disadvantages
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Leverage can earn greater gains
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Leverage can result in greater losses
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Increased flexibility
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Account fees and high-interest charges
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More flexibility than other loans
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Risk of margin calls and forced liquidation
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Potential for self-fulfilling cycle
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Potential for significant losses
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Conclusion
With margin money, you can enter into large positions by depositing a relatively small amount of capital. While this could potentially increase your profits, it also increases the level of risk. Therefore, you must first ensure that you thoroughly understand all of the risks involved before using margin money to trade.
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