Understanding Margin Trading: What it is?

First understanding Cash and Margin Accounts

A “cash account” is a type of brokerage account in which you pay the full amount for securities purchased and you cannot borrow funds from your broker-dealer to pay for transactions in the account. A “margin account” is a type of brokerage account in which your broker-dealer lends you cash, using the account as collateral, to purchase securities (known as “margin securities”). Brokerage firms may allow you to have both a margin account and a cash account at the same time. Margin increases your purchasing power (leverage), but also exposes you to the potential for losses.

Here's what you need to know about the margin

Let's say you buy a stock for Rs. 100 and the price of the stock rises to Rs. 150. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment (i.e. your Rs. 50 gain is 50% of your initial investment of Rs. 100). But if you bought the stock on margin paying Rs. 30 in cash and borrowing Rs.70 from your broker, you'll earn a 400 percent return on the money you invested (i.e. your Rs. 120 gain is 400% of your initial investment of Rs. 30).

*(For simplicity, this example does not account for the interest or other charges the investor would owe to the broker on the Rs. 70 margin loan he/she used to buy this stock. After paying this interest and charges to your broker, your actual return would be slightly less than calculated.)

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let's say the stock you bought for Rs.100 falls to Rs 50. If you fully paid for the stock, you would lose 50 percent of your money. However, if you bought on margin, you would lose more than 100 percent of your money. In addition to the 100% loss of your Rs. 30 initial investments, you would also owe your broker interest and any charges on the margin loan.

Investors who set up a margin account may, from time to time, be required to provide the broker with additional cash or securities if the price of the stock falls (a “margin call”). If the maintenance margin is not met, a broker has the right to sell the client’s securities that were bought on margin, without any notification and potentially at a substantial loss to the investor. If a broker sells a client’s stock after the price has plummeted, then the client would lose out on the chance to recoup his/her losses if the market bounces back.

Recognize the Risks

Margin accounts can be very risky and they are not appropriate for everyone. Before opening a margin account, the client should fully understand that:

• The client can lose more money than he/she has invested.
• The client may have to deposit additional cash or securities in his/her margin account on short notice to cover market losses.
• Client may be forced to sell some or all of his/her securities when falling stock prices reduce the value of securities.
• Broker may sell some or all of client’s securities without consulting to pay off margin loan.
• The client is not entitled to choose which securities the broker sells in accounts to cover his/her margin loan.
• Broker can increase its margin requirements at any time and is not required to provide you with advance notice.
• The client is not entitled to an extension of time on a margin call.

The client can protect him/herself by:

• Knowing how a margin account works and what happens if the price of the securities purchased on margin declines.
• Understanding that broker charges you interest for borrowing money and how that will affect the total return on your investments.
• Being aware that not all securities can be purchased on margin.
• Ask a broker or financial advisor, whether trading on margin is appropriate for you based on your financial resources, financial goal, investment objectives, and risk appetite.

Read Your Margin Agreement

To open a margin account, the broker will have the client sign a margin agreement. The margin agreement may be part of his/her general brokerage account opening agreement or may be a separate agreement.

The margin agreement states that the client must abide by the margin requirements established by the Guidelines of SEBON and NEPSE, be sure to carefully review the agreement before signing it.

As with most loans, the margin agreement explains the terms and conditions of the margin account. For example, the agreement describes how the interest on the loan is calculated, how the client is responsible for repaying the loan, and how the securities the client purchases serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your broker must give you before either selling your securities to collect the money you have borrowed or making any changes to the terms and conditions under which interest is calculated.

Know the Margin Rules

The Securities Board of Nepal and the Nepal Stock Exchange have Guidelines that govern margin trading. Brokerage firms can establish their own requirements that are more restrictive than those rules. Here are some of the key rules investors should know:

Initial Margin

Before trading on margin, SEBON rules, require you to deposit with your brokerage firm a minimum of 30 percent, cash or securities.

Maintenance Margin

After you buy margin securities, SEBON rules require brokerage firms to impose a “maintenance requirement” on your margin account. This maintenance requirement specifies the minimum amount of equity you must maintain in your margin account at all times. The equity in your margin account is the value of your securities less how much you owe to your broker. Currently, this is 20%.

Margin Calls

If your account falls below the maintenance requirement, your broker generally will make a margin call to ask you to deposit more cash or securities into your account. When a margin call occurs you generally cannot purchase any additional securities in your account until you satisfy the margin call requirements. If you are unable to meet the margin call, your broker will sell your securities to increase equity in your account up to or above the broker’s maintenance requirement. Currently, SEBON is required to make a margin call if the actual margin falls below 20%, The Broker might make a stricter requirement than this.

However, your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement if the actual margin falls below 15%. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your broker offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call if the actual margin falls below 15% or you ignore the call.

Interest Charges

Like all loans, margin loans charge interest and maybe other service charges. This cost directly reduces your return on investments, increasing the amount your investment needs to earn to break even. Interest rates can vary substantially between brokers and market conditions.

Account Transfers

If you plan to transfer securities from a margin account to another broker make sure you understand your current broker’s rules for transferring securities out of these accounts. Many brokers will not allow you to transfer securities out of a margin account if the account has an outstanding margin loan or any dues. These rules are generally included in your account agreement or a separate margin agreement you signed when opening the margin account.

By Rasbin Pandey

Pandey is a Business Development Executive at Nabil Securities Ltd. With a keen interest in the world of finance and investment, Rasbin is dedicated to sharing valuable insights with readers. As Nabil Securities Ltd. prepares to introduce margin lending, this article aims to provide readers with a foundational understanding of margin trading and its mechanics, enabling them to make informed decisions in the realm of investments and trading.