Leverage your gains
Trading in Mcx commodity using high intraday margin will give you more opportunity to increase the profit by effectively diversifying or hedging your portfolio. Buying shares on margin enables you to leverage your gains by enabling you to buy more shares than you could if you were doing so on a cash-only basis. The example below demonstrates how buying shares on margin can enable a return on investment that is almost double the return obtained without using margin.
Take advantage of trading opportunities
Trading shares on margin allows you to take advantage of trading opportunities as they arise, without having to raise cash by divesting your existing investments or from other sources.
Diversify your portfolio
Used judiciously, a margin account can be used to effectively diversify or hedge your portfolio. For example, if you are too heavily concentrated in a few stocks or sectors, your margin account can be used to add positions in other stocks or sectors in order to improve diversification. Or if you already own a diversified portfolio and wish to hedge downside risk, you can short sell the broad market or specific sector, or use options for hedging. Recall that short selling, and certain types of options trades, can generally only be done in a margin account
A carry trade refers to borrowing at a lower interest rate and investing in an instrument that can generate higher returns. While currency carry trades are widely used in the currency market, an astute investor can use it effectively in the stock market as well. For example, assume an investor with Rs. 50,000 to invest takes on margin debt of Rs. 50,000 and invests the full amount in a diversified portfolio that yields 12%. If the interest rate on the margin loan is 8.50%, the investor generates an additional 3.50% (or Rs. 1,750) on the overall portfolio, compared to the return on the cash-only or unleveraged portfolio.
Leverage is like fire. It can warm your house but it can also burn it down if it gets out of control. The key is to manage it. One way to do this is to stay fully invested in the market while managing leverage and getting the highest benefit from it. Knowledge of this strategy can help you opportunistically use leverage to grow a portfolio at a faster clip while still managing risk.
Trading on margin enables you to leverage securities you already own to purchase additional securities, sell securities short, or access a line of credit. While there are many benefits to establishing a margin account, it’s also critical to fully understand the risks before you get started. Before discussing the risks, let’s first examine the primary benefits of using margin.
The opportunity to leverage assets
When you buy securities on margin, you are able to leverage the value of securities you already own to increase the size of your investment. This enables you to potentially magnify your returns, assuming the value of your investment rises.
Federal Reserve Board Regulation T allows investors to use margin to borrow up to 50% of the value of a securities purchase. Therefore, if you wanted to purchase Rs. 10,000 worth of a stock, you could invest Rs. 5,000 of your own assets and use a margin loan to buy an additional Rs. 5,000 worth of shares, for a total investment of Rs. 10,000.
The ability to profit from share price declines
Short selling is a sophisticated strategy whereby an investor seeks to profit from a declining share price. In order to sell a security short, you must first borrow shares of stock from a brokerage firm, which requires that you have an approved margin account.
After you borrow shares, you sell them and then buy them back at a later date, presumably at a lower price. The difference between the proceeds of the original sale minus the amount required to buy back the shares would be your profit.
Assume that, after doing your research, you concluded that ABC Company was unlikely to meet its revenue goals due to a successful new product launch from ABC’s foremost competitor. You then use your margin account to borrow 100 shares of ABC stock and sell it short at Rs. 50 a share for a total of Rs. 5,000 (minus commission charges).
Six months later, ABC’s stock price has declined 20% to Rs. 40. You buy 100 shares at Rs. 40, return the 100 shares of stock to your brokerage firm, and pocket the difference of Rs. 1,000 (minus commissions, margin loan interest, and any taxes). This is another example of how trading on margin can provide opportunities to leverage your assets for financial gain.
The ability to diversify a concentrated portfolio
If your portfolio is dominated by a large block of stock from one company, such as a current or former employer, you could be putting too many eggs in one basket. With a margin account, however, you may be able to use those shares as collateral for a margin loan. You can then use the loan proceeds to diversify your portfolio without having to sell your original shares of stock. This strategy can be particularly helpful if you have a large unrealized capital gain and want to keep it that way.
A convenient line of credit
Once your account has been approved for margin borrowing, you can take out a margin loan at any time, without any additional forms or applications. This ready access to cash may prove to be convenient in a number of scenarios, such as when you are unemployed, experience an unexpected medical bill, or need a quick way to access cash for any other reason. If your brokerage account includes checking, you can simply write a check.
Low interest rates
Like any loan, you will incur interest charges with a margin loan. However, because margin loan rates are pegged to the federal funds target rate, your interest rate may be lower than what you would pay for a credit card cash advance or a bank loan, especially on larger balances. Margin rates may also be competitive with rates on home equity loans, without all the paperwork and application fees.
So long as your debt doesn’t exceed your margin maintenance requirement, you can pay back your loan on your own schedule.
The interest that accrues in the account may offset taxable income. Consult your tax adviser for details regarding your particular situation.
The ability to participate in advanced options strategies
Being approved for both a margin account and options trading allows you to place advanced options orders, such as spreads, butterflies, and uncovered options on equities, ETFs, and indexes. You can access additional information about trading options within the Fidelity Learning Center.
To facilitate participation in an employee stock option plan
Some employers offer stock options to their employees. This enables you to exercise an option to buy shares of stock at a discount to its present value. To exercise these options, you must have enough cash to pay for the shares. Using a margin account, you can use the securities in your account as collateral for a loan to pay the cost of exercising your options. This enables you to avoid selling securities and incurring a taxable capital gain, or using up all of your available cash.
Where there’s potential reward, there’s potential risk
While margin loans can be useful and convenient, they are by no means risk free. Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.
Margin can magnify your losses just as dramatically as it can boost returns.
Risk of being unable to meet a margin call
Your brokerage firm will require you to maintain a specific percentage of equity in your account, depending upon the types of securities you own and whether you borrow money to buy additional shares or sell short.
Equity reflects your ownership interest and is calculated by subtracting your margin loan balance from the total value of your account. For example, if the value of the securities in your account was Rs. 15,000 and your margin loan balance was Rs. 10,000, your equity would be approximately Rs. 5,000 or 33%. For stock positions, the minimum equity maintenance requirement is typically a 30% base but could be higher due to a number of security and/or account factors.
If the value of the securities you are using as collateral for your margin loan falls below the minimum equity maintenance requirement, your account may incur a margin call. This means you will need to add cash or securities to your account to increase your equity. If you do not act promptly, your brokerage firm may sell securities you own—without notifying you—in order to increase the equity in your account.
Ways to manage margin account risk
- Consider leaving a cash cushion in your account to help reduce the likelihood of a margin call.
- Prepare for volatility. Position your portfolios to withstand significant fluctuations in the overall value of your collateral without falling below your minimum equity requirement.
- Invest in assets with significant return potential. The securities you buy on margin should, at a minimum, have the potential to earn more than the cost of interest on the loan.
- Set a personal trigger point. Keep additional financial resources in place to contribute to your margin account when your balance approaches the margin maintenance requirement.
- Pay interest regularly. Interest charges are posted to your account monthly, so it makes sense to pay them down before they build to unmanageable levels.