Margin Trading

∗
Kumudini S. Hajra

An investor who purchases securities may pay for the securities fully in cash or
may borrow a part of the transaction value from his brokerage firm. Purchasing securities
by borrowing a portion of the transaction value and using the securities in the portfolio as
collateral is called margin trading. The term “margin trading” derives from the word
“margin”, which is the amount of money or equivalent value of eligible assets deposited
by the investor with his brokerage firm. It enables the investor to borrow money to
purchase more securities than he would have otherwise been able to do with his own
money, with the expectation that the stock prices will rise enabling him to reap greater
profits. The part of the purchase price that the investor must deposit with the broker, i.e.
margin, is the investor’s initial equity in the account. The loan from the brokerage firm is
secured by the securities that are purchased by the investor. Conversely, an investor may
also enter into a short sale through a margin account, which involves the investor
borrowing securities from the firm in order to sell it, hoping that the price will decline.
The margin trading thus leads to an increase in the purchasing/selling power of the
investors and increases the possibility of a larger gain if the stock market moves on
expected lines. At the same time, it magnifies the losses in case the stock market behaves
contrary to the expectation.

Essentially margin trading is another form of leverage trading. Leveraging implies

that backed by the collateral, one can buy assets, which are far greater in value than the
value of the collateral. The collateral is made up of stocks or other financial assets. The
reason why one uses leverage or borrows money is to amplify the gains. For example, the
investor purchases Rs. 100,000 worth of securities, with Rs. 50,000 as his own money
and Rs. 50,000 margin loan from the brokerage firm. If the price of the stock goes up by
10%, this implies that the investor’s own investment has appreciated by 20%. Without
leverage, the investor would have required his own funds of Rs. 100,000 to purchase the
same portfolio and his gain would have been 10%. Thus, leveraging leads to a doubling


Dy. Economic Adviser, NSE. The views expressed in this paper are of the author and not necessarily of
the employer.

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of the purchasing power, offers more flexibility to the investor and also presents the
possibility of doubling the return on investment. The higher the amount of funds
borrowed, the greater is the amplification effect.

While amplification effect is the main attraction for entering into margin trading,
it is also the foremost disadvantage of margin trading as it increases the riskiness of the
portfolio. One is as likely to make huge profits as one is likely to suffer huge losses while
trading on margin. Higher the leveraging element in one’s portfolio, higher is the risk
associated with margin trading. If one’s portfolio consists of securities, which are volatile
in nature, then leveraging such a portfolio will further amplify the gains/losses and can be
highly risky.

Margin vs. Cash Accounts

For margin trading, the investor needs to open a “margin account”, different from
a “cash account”, with the broker. In cash accounts, there is no element of credit and one
deposits the total value of purchases into the account. As compared to this, margin
accounts allow the investor to borrow a certain percentage of the value of his purchases,
using his securities as collateral. In effect, it implies taking loan from the broker. Just like
any other borrowing-lending, the investor owes the principal and the interest to the broker
who has lent money through a margin account. Typically, the brokers are ready to lend
up to 50% of the value of purchase by the investor. However, it is up to the investor to
borrow 50% or less. It is also important to note that all securities are not marginable
securities. Some securities cannot be purchased on margin and must be purchased in a
cash account. These are normally securities, which trade below a certain minimum price
or are highly volatile in nature with substantial risk to the investor as well as to the
broker, if purchased on margin.

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 Normally, trade commissions are same whether trades are done in cash or margin
accounts. However, the brokerage firm charges interest on the margin loans made to the
investor. The interest is a fixed rate stipulated by the authorities plus a mark-up
depending upon the exposure (debit balance) in the margin account. The interest rate on
the loan varies by brokerage firm and the amount borrowed. Generally, the higher is the
loan amount, the lower is the interest rate. The cost of margin trading to the investor thus
depends on the prevailing rate of interest for margin accounts, the amount of loan and the
period for which the money has been borrowed. The broker normally charges the interest
rate on the outstanding margin debt, at the end of say every month. The interest rate is
normally compounded on daily basis. As margin debt increases, the interest charges keep
on accumulating. Thus, the stock has to appreciate enough in value to cover the cost of
borrowing. Because of compounding, the cost of margin trading can be very high and one
has to be cautious about it.

Margin Requirements

Margin requirements aim at limiting trade sizes done in margin accounts. They
also prevent the broker from loosing all his money lent to investors. While the margin
requirements are fixed by the regulatory authorities, the individual brokerage firms are
free to set their own margin requirements- often called “house” requirements- as long as
they are higher than those fixed by the regulatory authorities. The brokerage firms fix
higher margin requirements if the securities in a margin account are particularly volatile,
thinly traded or concentrated in a single stock or single industry. This is done to help
ensure that there are sufficient funds in their customer accounts to cover the large ups and
downs in these stocks. Generally, the following types of margins are imposed:

Minimum Margin: The brokerage firm may ask the investor to deposit a certain
minimum amount or 100% of the purchase price, whichever is less, before trading
on margin. However, many firms do not insist on a minimum margin and may
provide finance based on initial margin.

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Initial Margin: The portion of the purchase price that the investor deposits with the
broker is called the ‘initial margin’. In the US, the Federal Reserve Board has
fixed the initial floor on minimum acceptable amount of equity in a margin
account at 50%. Thus, the brokerage firms allow the investors to borrow upto
50% of the purchase value of securities. However, some brokerage firms have set
the initial margin requirement as high as 67%.

Suppose the investor wants to purchase 1,000 shares at a price of Rs. 100 per
share. The purchase price thus works out to Rs. 100,000, which can also be termed the
current market value (CMV) or the gross portfolio (P g). The initial margin at 50% is Rs.
50,000. This is the amount, which must be present in the margin account to purchase the
securities. The rest of the amount, i.e. debit balance of Rs. 50,000 is provided by the
broker. This is also known as margin debt. The equity balance in the account or the net
value of the portfolio (Pn) is Rs. 50,000. The equity balance can be worked out by
subtracting the amount of margin debt from the current market value of the stock. The
debit balance and the equity balance always add up to CMV or Pg (i.e., Pg = Margin Debt
+ Pn).

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Maintenance Margin: It is the minimum level of equity balance that should be
maintained in the account at all times. If the equity balance in the margin account
falls below this level, then the broker will insist that the investor deposits additional
funds or he can sell the stock in the account to bring down the margin debt. Though
the maintenance margin requirement varies for different brokerage firms, the normal
practice is that if the equity balance in the margin account falls below 25% of the
CMV of the portfolio, the broker issues a margin call. In other words, if percentage
margin (which is nothing but Pn as per cent of Pg) reaches 25%, the investor faces a
margin call and runs the risk of a partial or complete sell-out. In the US, in addition
to the initial margin floor set by the Federal Reserve, the stock exchanges, like
NASD and NYSE, have specified maintenance margin requirements.

Margin Call

When the equity balance in the margin account falls below the floor acceptable to
the broker, he can make a “margin call”. The floor at which the broker can make the
margin call depends upon what is fixed by the regulatory authorities and the norm
followed by the broker.

When the broker makes a margin call, the investor is required to deposit more
cash or securities into his account. If the margin call is not met, the broker has a right to
sell the securities in the margin account to increase the equity level in the account above
the minimum margin requirement. This is explained in Graph 1, which plots the gross
value of portfolio, margin debt and the net value of portfolio. Ignoring the interest cost
and using the same figures as used above to explain margin requirements, the margin
debt is represented by a flat line at the level of Rs. 50,000. Thus, at point 0, the current
value of the portfolio is Rs. 100,000. With 50% norm, the initial margin works out as Rs.
50,000. The Graph depicts what happens when the portfolio appreciates/depreciates in
value by different percentages. The right half of the Graph presents the scenario when the
stock is appreciating in value and the investor as well as the broker does not face any risk.
In this situation, the investor has ‘excess equity’ in his account, which he may withdraw
in cash or use it to buy more stock or simply reserve the right to do any of this in future.

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If the portfolio appreciates in value by 10%, his account is worth Rs.110,000. Keeping
50% of this as initial margin, the investor can purchase an additional Rs. 10,000 of stock
without putting up any additional capital.

Graph 1: Margin Trading - An Illustrative Example

160,000

140,000

120,000
Value in Rupees

100,000

80,000
Margin Call

60,000

40,000

20,000

0
-50 -40 -30 -20 -10 0 10 20 30 40 50
Depreciation/Appreciationof Portfolio, inpercent

Gross Value of Portfolio Margin Debt Net Value of Portfolio

Conversely, let us presume that the stock purchased with margin debt declines in
value by 10%. The CMV or Pg falls to Rs. 90,000. The debit balance remains same as Rs.
50,000, while the equity balance has dropped to Rs. 40,000. This means that the investor
cannot borrow more money, as he does not have enough money in his account to meet
the initial margin requirement of 50%. He can purchase additional securities only if he
deposits additional funds to meet the initial margin requirement for new transaction. At
this point, if the investor wants to sell some or all of the securities in his account, the
broker will have a right to retain a part of the proceeds of the sale to reduce the investor’s
debit balance. If the value of the portfolio continues to fall further, the brokerage firm
will insist on maintaining at least 25% of the CMV in the margin account. This ensures
that the value of securities will never fall below the amount of the margin loan. When the
portfolio depreciates in value by 33%, the investor faces the risk of a margin call since at
this level his percentage margin has declined to 25%. This is represented by the thick
vertical line in the Graph. If the investor gets a margin call, he will be required to bring in
additional funds before a set time/date. If the stock prices continue to fall and the equity

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in the account drops further, the broker may sell the investor out even without waiting till
given time/date.

Short sale through a margin account also works in the similar manner. If the
investor expects the stock prices to decline, he would borrow securities from his
brokerage firm to sell them now and he would purchase the same securities at lower
prices in future and repay the broker. In the process, the investor would make profit by
selling at high prices and purchasing at lower prices. For example, the investor wants to
sell securities worth Rs. 100,000 (1,000 shares at a price of Rs. 100 per share) and
deposits initial margin of 50%. He borrows securities worth Rs. 50,000 from his
brokerage firm. Suppose the price of the securities sold by the investor comes down by
20% to Rs. 80 per share. The investor is now in a position to purchase back 1,250 shares
with Rs. 100,000. Thus, he is now in possession of 250 more securities than what he had
earlier sold. Of course, for the investor to make a net gain, the stock prices would have to
fall enough to cover the cost of borrowing. It may also be noted that normally brokerage
firms are ready to lend stocks upto 40% of the sale value, implying that margin
requirements are stricter in case of short sales.

The margin accounts are governed by a margin agreement signed by the broker
and the investor. Normally, the brokerage firm is not even required to make a margin call
or notify the investor that equity in the account has fallen below the minimum
requirement. They can simply start selling the securities to meet the shortfall in the
account. The investor therefore has to remain vigilant about the account balances. This is
because when the stock market is declining, the value of the collateral is also declining
and so also the value of the securities purchased with the loan. Not meeting the margin
call means that the broker can offload these securities in the market to meet the shortfall
in the margin account and the proceeds of the sale go directly to meet the repayment of
margin debt. The losses can get compounded by the fact that the investor loses control
over deciding which stocks should be sold and at what price. The stock prices may
rebound later, but the investors still have to pay principal and interest for stock they no
longer own. It is therefore better to bring in additional funds much before the investment
has gone bad.

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Caveats

The investors venturing into margin trading need to be aware of the several risks
associated with margin trading. While some of these risks have been mentioned earlier,
they are summarised below:

 In a declining stock market, the losses get amplified in a margin account, with the
potential threat of losing more money than one had originally invested. If the value of
securities purchased on margin declines, then the investor is required to provide
additional funds to the brokerage firm to avoid forced sale of those securities or other
securities in the account.

 For meeting margin deficiency, the firm can sell the securities in the investor’s
account at the current price available in the market. This price may not be the “best”
price at which the investor himself would have preferred to sell his stock. Further, the
investor continues to remain responsible for any shortfall in the account even after
such a sale.

 Generally, the margin trading rules allow the brokerage firms to liquidate securities in
investor accounts without contacting the investor. Most of firms try to intimate their
investors of the margin call, but they are not required to do so. This is a source of
additional risk.

 When the firm makes a margin call, the investor is required to respond to it
immediately. Normally, one is not entitled to an extension of time to meet initial
margin requirements, while some firms may allow some time to meet a maintenance
margin call. The investors will thus have to keep some extra cash with then, which
they can bring in when needed.

Similarly, the brokers need to remain alert. The risks to them may arise due to following
factors:

 The brokers may not be able to follow prudent risk management practices.
Attempting to estimate the credit worthiness of the investor based on previous day’s

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 data can put the brokerage firm in a tight spot in the event of dramatic and sudden
market drops.

 The brokerage firm, which is acting like a lender, makes money on margin accounts
by charging interest on debit balances. However, recovering the principal and the
interest on the margin debt can be especially tricky in a declining stock market.

 The brokers’ systems may keep a check on credit limits on an individual basis only,
but may not be able to generate a real time measure of enterprise-wide risk. In a high
volume environment, the brokers would require to establish a system that can plug in
up-to-date data and events and generate margin calls on real time basis. This would
support day trading and intra-day margin calls.

Indian Context

Margin trading is prevalent in most of the markets, which have switched over to
rolling settlement. The pertinent question is whether Indian markets are ready for
something, which is as risky as margin trading. The investors in India till now had
options of ALBM/BLESS and ‘badla’, which allowed one to carry forward the positions
for some time. In margin trading, both the broker and investor are well aware of the credit
element involved beforehand and the broker can take adequate precautions, like imposing
stricter margin requirements depending upon the type of securities in which the
investment is being made and scrutinising the creditwothiness of the investor before the
loan is made.

There is no doubt about the fact that some kind of lending and borrowing
mechanism is a must for enthusing investor interest in the market. No market can be
vibrant and offer sufficient liquidity without speculators or day traders. The volumes in
which day traders operate are not sustainable if they were to operate strictly with own
funds. Now that ALBM and ‘badla’ are gone for good, one needs to introduce some
financing mechanism. And margin trading, which has been prevalent for long in many
markets, is one good option. However, to the extent that margin trading is akin to
leveraged trading, one needs to put in place adequate checks to contain the risk element.

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 Over time, the brokers’ fees have been steadily declining. The permission to open
margin accounts for investors will offer another avenue to brokers for earning income on
account of interest on such accounts. This will help keeping them in business. However,
brokers will in turn have to obtain funds from banks. At present, restrictions have been
placed on bank financing of equities. One has to decide if banks can be allowed to invest
indirectly in the stock market by channelising funds though the brokerage firms rather
than providing direct finance to investors.

The foremost pre-condition for introducing margin trading in India will be to

create widespread investor awareness about margin. Before investing, the investor needs
to fully appreciate the costs and risks of investing on margin. The Securities and
Exchange Commission, the regulator for securities market in the US, has launched an
intensive investor education exercise on its web-site, focussing on risks and costs
associated with margin trading and several other new products.

One will also have to address the issue of who will regulate margin trading, if
introduced in India. In the US, it is the Federal Reserve Board, which lays down the
minimum criteria. Further norms are laid down by the self-regulators, like stock
exchanges and the brokerage firms themselves. To the extent that brokerage firms are
acting like a non-banking finance companies while providing margin loans, it will have to
be decided which norms will apply to the these firms with respect to prudential limits.

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