What is Margin Trading Facility? How it works and risk associate with it

Margin trading works by opening a margin account with a brokerage firm or an exchange. Traders are required to deposit a certain percentage of the total trade value, known as the margin requirement. The brokerage firm then provides the remaining funds as a loan, secured against the trader's existing assets or the purchased securities that serve as collateral. 

This borrowing arrangement increases the trader's purchasing power and allows them to engage in larger trades. The use of leverage can be particularly attractive to traders looking to capitalise on short-term market movements or take advantage of opportunities that require a higher capital investment.

How does Margin Trading Facility Work?

As mentioned earlier Margin trading allows traders to borrow funds from a brokerage firm or exchange to increase their purchasing power and engage in larger trades. Here's a step-by-step explanation of how margin trading typically works.

Opening a Margin Account

The trader begins by opening a margin account with a brokerage firm or an exchange. This account is distinct from a regular cash account and is specifically designed for margin trading.

Margin Trading Facility Requirement

The trader must deposit a certain percentage of the total trade value, known as the margin requirement. The margin requirement varies depending on the financial instrument being traded and the policies of the brokerage firm. This margin acts as collateral against the loan provided by the brokerage firm.

Borrowing Funds

Once the margin account is opened and the initial margin requirement is met, the brokerage firm lends the trader the remaining funds needed to execute the trade. The loan amount is determined based on the margin ratio, which specifies how much of the trade value can be borrowed.

Trading Securities

With the borrowed funds, the trader can now buy or sell securities, such as stocks, bonds, commodities, or derivatives, depending on the available options provided by the brokerage firm. The trader has increased buying power and can engage in trades that would be beyond their financial capacity using only their own capital.

Margin Interest
As the trader is using borrowed funds, they are required to pay interest on the loan amount. The interest rate charged on the borrowed funds is determined by the brokerage firm and can vary depending on stock market conditions and the trader's creditworthiness. Interest is usually calculated based on the daily outstanding balance of the loan.

Monitoring Margin Level

While the trade is active, the trader needs to monitor their margin level. The margin level is the ratio of the trader's equity (the total value of their assets minus the borrowed funds and any outstanding liabilities) to the total value of the trade. It helps determine the trader's risk exposure and whether they are meeting the required margin maintenance level.

Margin Calls

If the value of the securities held in the account falls below a specified threshold (known as the maintenance margin), the brokerage firm may issue a margin call. A margin call requires the trader to deposit additional funds or securities to restore the required margin level. Failure to meet a margin call may result in forced liquidation of the trader's assets to repay the loan.

Closing the Trade

When the trader decides to close the position, they sell the securities they bought or buy back the securities they sold. The proceeds from the trade, minus any transaction costs, are used to repay the borrowed funds, and any remaining profit or loss belongs to the trader.

Margin Trading Facility Risks and Considerations:

Increased Volatility

Margin trading amplifies both gains and losses. While it can lead to significant profits, it can also result in substantial losses if the market moves against the trader's position. The increased leverage increases the exposure to market volatility, and even small price fluctuations can have a magnified impact on the investment.

Margin Calls and Forced Liquidation

Margin trading involves the concept of margin maintenance, where traders must maintain a minimum margin level to avoid a margin call. A margin call occurs when the value of the securities held in the account falls below a specified threshold, prompting the brokerage firm to request additional funds or securities to restore the required margin. Failure to meet a margin call can lead to forced liquidation of the trader's assets, potentially incurring significant losses.

Interest Payments

Margin accounts require traders to pay interest on the borrowed funds. These interest charges can erode profits, especially if trades are held for an extended period. It is crucial for traders to consider the cost of borrowing and factor it into their trading strategies to ensure it remains sustainable.

Conclusion

Margin trading facility can be a powerful tool for experienced traders seeking to leverage their investments and take advantage of market opportunities. It provides access to increased buying power and a broader range of assets. 

However, the risks associated with margin trading demand careful consideration and risk management strategies. Traders should approach margin trading with a clear understanding of the mechanics, potential benefits and inherent risks to make informed decisions and navigate the financial markets effectively.