The Pros and Cons of Using Margin Trade Funding

In this article, we will discuss

• What is Margin Trade Funding?
• How Does Margin Trade Funding Work?
• What are the Advantages of Margin Trade Funding?
• What are the Disadvantages of Margin Trade Funding?
• Conclusion

Of late, margin trading is quickly gaining popularity. In fact, it has become the go-to strategy for traders and investors who wish to amplify their gains. However, despite the many advantages that trading on margin may offer, it also comes with significant risks.

If you are planning to use margin trade funding to increase the potential returns from your investments or trades, you need to understand both the benefits and drawbacks of the facility. In this article, we will explore the concept in detail, understand how it works with the help of an example and delve into the various advantages and disadvantages of using the facility to trade in the financial markets.

What is Margin Trade Funding?

Margin trade funding, also known as a margin trading facility or MTF, is a facility stockbrokers offer that allows you to enter into large positions by depositing only a part of the total trade value as a margin. The stockbroker would fund the remaining portion of the trade value. The broker will levy interest at a nominal interest rate in exchange for providing you with the funds necessary to execute the trade. This interest is levied daily from the date of borrowing funds until you close out your position and repay the borrowed funds.

The securities you purchase through margin funding are pledged as collateral as an additional safety measure. If you fail to repay the borrowed funds along with the accumulated interest, the broker will automatically liquidate the pledged securities and use the proceeds to close out your loan.

How Does Margin Trade Funding Work?

Now, let us consider a hypothetical example to better understand how margin trade funding works.

Assume you have Rs. 50,000 in your trading account. You want to buy 100 shares of a company whose shares are currently trading at Rs. 2,000 per share. To execute this trade, you would need Rs. 2,00,000 (Rs. 2,000 x 100 shares). However, you only have Rs. 50,000 in your account, which would be enough to purchase only 25 shares (Rs. 50,000 ÷ Rs. 2,000). So then, how do you execute this trade? With MTF, it is possible.

Let us assume that your stockbroker offers an MTF facility, where you can avail up to a 4X trading margin. With the 4X leverage, you can purchase Rs. 2,00,000 worth of shares by simply depositing Rs. 50,000 as a margin. Your stockbroker will provide the remaining Rs. 1,50,000 needed to execute the transaction at an interest rate of 18% per year. Your broker, meanwhile, will pledge the 100 shares of the company you purchased using the margin trading facility as collateral.

Let us say that you have held the position for 60 days. During this period, the share price rises from Rs. 2,000 per share to Rs. 2,200 per share. You decide to liquidate your investment and realise the gains. The total profit you would have made from this transaction would be Rs. 20,000 [(Rs. 2,200 - Rs. 2,000) x 100 shares].

However, since you borrowed funds amounting to Rs. 1,50,000 from your broker to purchase the shares, you are liable to pay interest for 60 days at the rate of 18% per year. This amounts to Rs. 4,438 {[(Rs. 1,50,000 x 18%) ÷ 365 days] x 60 days}. The total profit from the transaction, after accounting for the interest costs, would be Rs. 15,562 (Rs. 20,000 — Rs. 4,438). 

But what if the share price falls instead of rising? What would happen in that case?

If the losses exceed or are about to exceed the amount of margin you deposited to initiate the trade, the broker sends a margin call, asking you to deposit an additional margin to cover the losses. Failing to meet the margin call will result in the broker automatically selling off the pledged securities to settle your obligations.

What are the Advantages of Margin Trade Funding?

With the concept of margin trading out of the way, let us now focus on the various advantages you get to enjoy by using this facility.

• Increased Purchasing Power

Margin trade funding can significantly increase your purchasing power. By borrowing funds from your stockbroker, you can take up positions much larger than what you can with just your funds alone.

For example, with just Rs. 10,000 in your trading account, you can only purchase 10 shares of a company whose shares are trading at Rs. 1,000 per share. However, with a margin trade facility offering 4X leverage, you can increase your purchasing power by 4 times, bringing it up to Rs. 40,000. With the increased funds, you can now purchase 40 shares of the same company.

• Opportunity to Capitalise on Short-Term Market Movements

The Indian financial markets present a plethora of opportunities to earn returns. However, most of these opportunities tend to be short-lived. Unless you have the requisite funds in your account, you may not be able to capitalise on attractive short-term market opportunities. With the margin trading facility, however, you can quickly capitalise on favourable market conditions and profit from price movements even if you lack sufficient funds.

• Potential for Higher Returns

The primary advantage of margin trading is the potential for higher returns. By leveraging borrowed funds, you can amplify your gains significantly by taking up much larger positions than you would have been able to had you used your capital alone.

For instance, let us assume that you have only Rs. 5,000 in your trading account. You wish to purchase a stock with a purchase price of Rs. 150 per share. With your capital alone, you can only purchase 33 shares. If the share price rises by Rs. 10 per share, your profit would be Rs. 330 (33 shares x Rs. 10 per share).

Let us compare this with a trade using MTF. Suppose your broker offers a 4X trading margin. With Rs. 5,000 in your account, you can take up positions worth Rs. 20,000 (Rs. 5,000 x 4). With Rs. 20,000, you can purchase 133 shares of the same company. Assuming that the share price rises by Rs. 10 per share, your profit would be Rs. 1,330 (133 shares x Rs. 10 per share).

As you can see, you were able to significantly increase your profit potential by opting for a margin trading facility without actually increasing the amount you invested.

• Diversification Opportunities

With margin trading, you can diversify your portfolio and reduce the risk associated with holding a concentrated position without infusing any additional capital. You can spread your investments across various stocks even with limited capital. Let us look at how you can do it.

Assume you have Rs. 12,000 in your trading account. Instead of directing your funds entirely to one stock, you can split it into four equal parts of Rs. 3,000 each and use the MTF facility to invest in four different stocks. Assuming that the MTF facility provides 4X leverage, you can create a diversified portfolio consisting of four stocks, investing Rs. 12,000 (Rs. 3,000 x 4 times) in each stock.

• Access to High-Value Stocks

Margin trade funding enables you to buy high-value stocks that you might not be able to afford with your own funds. Owning shares of premium companies could potentially lead to significant gains.

Stocks like MRF Limited, Abbott India, 3M India and Bosch are a few examples of stocks with very high per-share prices. Since these stocks are of such high value, they are usually not accessible to a large section of retail investors. However, with margin funding, you can get access to all of these stocks easily.

• Flexibility

Contrary to popular opinion, the margin trading facility is not only useful for capitalising on short-term trading opportunities. In fact, many stockbrokers offer unlimited holding periods on stocks purchased on margin. This essentially gives you the flexibility to execute a wide range of trading strategies. In fact, you can even execute a long-term buy-and-hold strategy if you expect substantial appreciation in the stock in the long run. Furthermore, you can also employ hedging strategies, where you hedge the risk against other investments in your portfolio using MTF.

• Convenience

Most margin trading facilities are very easy to access and use since they are usually integrated into the broker’s trading platform. Such a high level of convenience makes executing margin trades easier and supports quick decision-making and execution of trades, which is very crucial in a fast-moving market.

What are the Disadvantages of Margin Trade Funding?

Although the advantages offered by margin trading are irrefutable, it is equally important to recognise the associated risks and drawbacks of the facility. Let us explore some of the key disadvantages of MTF.

• Amplified Losses

Many market experts compare leverage to a double-edged sword. Though it is true that the use of leverage could potentially increase your profits, it could also magnify your losses if the markets move against you. If the value of the securities you purchased on trading margin declines, you could end up losing more money than what you initially invested.

For example, assume you use your broker’s 4X margin facility to purchase Rs. 40,000 worth of stocks by investing just Rs. 10,000. Now, with the increased funds, you can purchase 400 shares of a stock trading at Rs. 100 per share.

Let us say that the market suddenly decides to move against you due to increased volatility and that the share price drops to Rs. 70 per share. In this case, your losses would be Rs. 12,000 [(Rs. 70 - Rs. 100) x 400 shares], which is more than what you invested initially.

• Interest Costs

As you have seen already, trading on margin incurs interest, which can reduce your profits or increase your losses. Moreover, the interest rates on margin trade funding usually tend to be very high and can quickly add up, especially if you hold your positions for an extended period.

For example, let us say that you borrow Rs. 80,000 from your stockbroker to purchase shares. Assuming that the MTF interest rate is 18% per annum and you hold your positions for 6 months, your total interest cost would come to around Rs. 7,200 {[(Rs. 80,000 x 18%) ÷ 12 months] x 6 months}. This interest cost of Rs. 7,200 can reduce your profits or widen your losses further.

• Margin Calls

Stockbrokers issue margin calls when the value of the securities purchased via trading margin falls below a certain threshold level. Once a margin call is issued, you must deposit additional funds to cover the margin shortfall within the stipulated time provided.

If you are unable to meet margin calls within the stated timeline, your broker will square off your open positions automatically. This could end up forcing you to realise losses and may even destabilise your investment strategy.

• Increased Emotional and Psychological Stress

The high-risk nature of margin trading can lead to significant psychological stress. The potential for large losses, combined with the constant need to monitor positions to prevent margin shortfalls, can create anxiety and pressure. The increased emotional stress could potentially affect decision-making and lead to suboptimal trading strategies and outcomes.

• Potential for Overtrading

The easy availability of leverage offered by the margin trading facility might inadvertently encourage you to trade more frequently, leading to overtrading. This can result in higher transaction costs, increased exposure to market volatility and the potential erosion of capital due to frequent trading losses.

Conclusion

Margin trade funding is a powerful tool that can significantly amplify your gains. It can also enable you to take advantage of short-term market opportunities with increased purchasing power. However, if you are considering using a margin funding facility, it is important to be aware of the various risks and disadvantages associated with it. Remember to weigh the pros and cons of the facility carefully and ensure that you are prepared for the potential downsides using robust risk management strategies.

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