Small investors, avoid margin trading

The financial markets regulator -- the Securities and Exchange Board of India -- has taken a resolute step forward to bring the Indian capital markets further on par with other international markets.

The Sebi board has approved the introduction of margin trading and is expected to commence from February 1, 2004. An official notification is likely to be issued shortly.

With the clearance for margin trading, India's systems come on par with the international markets -- like those of the United States, the United Kingdom, Canada, Singapore and Hong Kong.

Margin trading comes as a logical extension to developments like computerised trading and dematerialisation of shares.

Further, with the removal of carry-forward trading and related products, the Indian markets and investors were in need for an official and streamlined system of financing, which has now come about.

So what is margin trading?

Margin trading is a high-risk strategy that allows you to buy more stock than you would be able to normally and can yield a huge profit if executed correctly.

Buying on margin means to borrow money from a broker (similar to a loan) to purchase stock.

The investor can take position in the market by paying an initial margin of 50 per cent (your own money), while the broker could finance the balance 50 per cent.

The broker can lend from his own resources or can borrow from banks, non-banking finance companies and other qualified lenders such as insurance companies.

However, the broker can only borrow up to five times his net worth.

The broker cannot use the funds from other clients or individuals.

Sebi has stipulated that only corporate brokers with a net worth of more than Rs 3 crore (Rs 30 million) can carry out margin trading on behalf of their clients.

How does margin trading work?

Opening a separate account: To trade on margin, one needs to open a margin account. This is different from the regular cash account in which you trade using the money in the account.

The broker will be required to obtain your signature to open this margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement.

Let us look at how margin trading works.

Say you wish to buy 500 Reliance Industries shares but do not have the entire finance upfront. You could do the trade through margin trading, wherein you would bring in 50 per cent as the initial margin (through your own funds) and the broker would provide the balance 50 per cent funds.

In this same case, if you feel that the Reliance Industries stock has a potential to provide 25 per cent returns, you could buy more, by equally bringing in more money and borrowing the balance from the broker.

There are some key issues that have to be kept in mind while opting for margin trading.

• First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan, until it is fully paid.

The stocks are kept as collateral for the loan taken and remain in the broker's possession.

• Secondly, the investor has to keep a minimum amount of equity (as maintenance margin) in the margin account, which can range from 25-40 per cent.

This balance must be maintained before the broker forces you to deposit more funds or sell stock to pay off your loan.

Note: If the value of the security or stock falls and the margin falls below 40 per cent, then the amount (as margin) will have to be increased again.

A broker will make a 'margin call' if one or more of the securities you have bought (with borrowed money) decreases in value past this point.

The investor will then have to pay the margin on a T+1 basis, i.e., the cheque would have to be paid to the broker the next day.

In case the margin falls below 30 per cent, then the broker -- without intimating you - could also sell the stock in the market.

In the case of higher profits, the interest on the loan taken will have to be paid. The interest charges are applied to your account unless you decide to make payments.

These interest charges in current market conditions are high and differ from broker to broker.

Over time, your debt level increases as interest charges accrue against you.

"Currently these interest charges are very high, as this system has been relatively unregulated. In the new system, the interest charges could come down. Further, we expect demand for margin trading to be high considering the investor interest in the stock markets," a dealer in the investment division of a state development bank said, on condition of anonymity.

How different is margin trading from other finance schemes?

In principle, margin trading is similar to 'badla financing,' but there are more stringent norms governing this.

Currently, only banks are permitted to undertake margin funding of investors. However, this method of margin trading failed to take off due to stiff conditions imposed on the banks by the Reserve Bank of India.

The onus is placed on the bank's board to ensure that there is no nexus between inter-connected stock broking entities/stockbrokers and the bank.

Stringent disclosures: Sebi is working out the final modalities; it has specified that strict disclosures will have to be maintained for margin trading.

Brokers will have to disclose on a daily basis, their client-wise, scrip-wise and lender-wise positions to the stock exchanges.

The exchange will disclose details of scrip wise margin financing to the public.

Limited scope: Margin trading will be allowed only in the top scrips, taken from the Bombay Stock Exchange's specified 'A' group, i.e., those with a impact cost of less than 1 per cent which signifies high liquidity, the regulator has said.

What it means for the broker: The broking community has been through rough times in the period 2000-2002. However, most have had a windfall in 2003 with the current bull run.

But competitive pressures will force the broking industry to constantly seek new areas for growth and revenues. Margin trading has become one such avenue.

It also brings the stock broking community to a slightly higher status as an industry/corporate entity, which carries out varied financial services.

Should retail investors opt for margin trading?

There are clear benefits from margin trading, offering you leverage for your trade. If the scrip you have bought moves up, one can make handsome gains.

On the flip side, a fall in prices would mean shoring up the maintenance margin (bringing in more money) or liquidating the stock.

Further, interest has to be paid on the sums borrowed. Hence, one could actually stand to lose more money than originally invested.

Leading BSE institutional brokerage firms like KJMC Capital Markets and ULJK Securities say that margin trading would benefit the high net worth individuals more than retail investors.

We feel the retail investor must keep from jumping into margin trading immediately due to the following factors:

• Any financial and trading system in Indian market conditions will need some time to settle down. There will be hiccups and possibly changes in the margin trading system, as required.
• Margin trading is a high-risk strategy. You stand to make higher profits, but might also lose heavily, if the market conditions move against you.
• Indulge in margin trading only if you have 'risk capital'. Risk capital is surplus money set aside, which the investor can afford to lose.
• Buying on margin should be used for short-term investments. The longer you hold an investment, the greater a return you need, to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.