Margin money is the part money put up by an investor with the rest borrowed from brokers or banks to buy shares. Brokers/banks offer the margin facility both to increase their business and to service existing customers. They typically charge between 11 and 16 per cent per annum. A broker has the right to liquidate the securities of the investor if the latter fails to meet the margin call requirements or to deposit the cheque for the specified amount a day after the margin call is made. The broker is also well within his rights to sell the shares if the cheque deposited by the investor bounces.
Also, if the investor's deposit in the margin account falls to 30 per cent or less of the latest market value of the securities, in the period between the margin call and the receipt of payment from the investor, the broker can sell the shares to get the amount under consideration.
Banks and brokers offer this facility only for specified scrips. So an investor planning to opt for this route should check if the share he is planning to invest in is part of the specified list.
A margin call is said to have been made when the broker asks the investor to pay some of the money borrowed by the investor to buy securities or shares. Such calls are typically made when the value of the shares bought fall.
Let us assume that Mr. Roy buys 100 shares in ABC Ltd at Rs 500 per share. He borrows half the amount, that is, Rs. 25,000, from the broker or banker. The stock of ABC Ltd then falls to Rs. 400 per share. At this the broker calls for more margin money from Mr. Roy.
If Mr. Roy is unable to pay the increased margin money the broker sells some of the ABC shares to meet the shortfall. The shortfall is the difference in the amount of money that the broker asked and the investor paid.
If the market had gone up, that is if the shares of ABC Ltd had gone up by Rs. 50 to Rs. 550 in a week, then Mr. Roy would have made a profit of Rs. 5,000 on his investment of Rs. 25,000. He would, of course, have to pay the interest on the funds he borrowed out of this.
Such selling by the broker leads to a further fall in the price of the share, thereby triggering another bout of margin calls, shortfalls and selling of shares at a low price. Investors with highly leveraged positions (that is those who have borrowed heavily to invest in shares) can lose a lot in a falling market, especially if they are unable to maintain the minimum margin levels called for by their lenders.
It is important to remember that margin calls are a routine feature of trading. However, they make their presence felt whenever the market falls or goes into correction mode.
If an investor is unable to meet the margin call, they tend to lose the opportunity to make a profit when the market goes up again.
It is also possible to buy shares by paying the entire value up front, that is, without availing of the margin facility. In such a scenario, Mr Roy would have been able to purchase only 50 shares of ABC Ltd. This reduces his potential profit in the transaction by half. However, the bright side of this situation is that Mr. Roy need not resort to a distress sale of his shares when the market is in a bear phase, but wait for the share to go up in value.
This analysis clearly shows that margin trading is only for those with an appetite for high risks. More sober investors, who might be unable to bear heavy loses should not venture into this field.