Margin Trading is high volume, high risk trades that gives you more exposure with little money. What it does is that it increases your returns and rewards, make it very volatile and high risk trades.
Understanding margin trading with an example
If you have Rs 1 lakh and you want to buy shares of Reliance Industries, you can buy just 100 shares of Reliance, if the price was Rs 1000.
What are the benefits of margin trading?
As can be seen from the above example, what you have done is increased your exposure 7 to 8 times in the above example. So, if the share price of Reliance Industries falls from 1000 to Rs 900, under margin funding you would be making a loss of Rs 7000, while under normal trading where you pay your own money and buy the shares in the cash market, you would be making a loss of just Rs 1000.
Similarly, if the share would go to Rs 1100, you would be making a profit of Rs 7000, as against Rs 1000 originally.
What margin trading does is that it allows you to increase your exposure, thus increasing your risk at the same time. So, the benfit of margin trading is higher volumes with greater chance of making more money with a small amount.
How the margin trading works?
You first have to deposit your initial cash margin. For example, if the broker likes 20 per cent, you would have to first deposit that margin get exposure to Reliance Industries for as mentioned above.
Now, if the shares keep falling, the broker will ask you to deposit additional cash to make good the margins.
Now, if you are not able to deposit the amount for losses, the broker would immediately sell the shares to avoid further losses. This is called triggering the margin call.
Let us give an example. If you buy 1000 shares of ITC at Rs 100 (just hypothetical prices), the total cost would be Rs 1 lakh. If the broker allows 20 per cent margin, you can go ahead and buy 5000 shares of ITC. Now, if you buy 5000 shares of ITC and the stock falls to Rs 90, the broker would ask you to deposit the additional loss amount of Rs 50,000.
If you fail to deposit the same, he would sell the shares and recover his money. Remember, the broker would not make a loss, since he has taken a good 20 per cent margin and the shares have fallen only 10 per cent.
What happens if there is a profit or loss in margin trading?
When there is a profit, if the share price climbs in case of a long purchases, you can sell the shares. The concerned broker would credit your bank account with the profit or you can buy some shares and take additional exposure.
If there is a loss, you need to deposit the loss amount and can square off your position. The balance of the amount would be returned by the broker to you.
You can also trade in derivatives for margin trading purposes.
What are the documents needed for margin trading?
Many brokers get into a very formalized documentation process, before they allow you to do margin trading.
For example, Kotak Securiries would need to sign a margin trading agreement on a stamp paper, before you venture into the same. You can check your accout online, to see the profits, losses etc, when it comes to margin trading.
Should you really engage in margin trading?
Margin trading is a really risky proposition. The exposure is high, which makes it difficult and highly risky. If you have penchant for risk, go for it. Or else you can refrain from the same.
You need skill and knowledge to trade using this mechanism. Since the volumes are large, the chances of making or losing money is also higher.
Apart from buying, you should also know when to book losses and take your profits off the table. All this is meant for professional traders. So, if you lack the knowledge avoid margin trading.