Investors buy shares by investing their money up front. Margin trading is borrowing money from a broking house to purchase shares. It is a leveraging mechanism that enables investors to take exposure in the market over and above what is possible with their own resources.
Buying on margin
Let us assume that investor A has R1,00,000 in his bank account for the purpose of buying some shares. He can use this amount to buy 250 shares of company X at the rate of R400 each, excluding brokerage charges. In the normal course, he will pay for the shares on the settlement day to the exchange and receive 250 shares, which will be credited to his demat account.
Under margin trading, this money, i.e., R1,00,000 is used as margin and assuming that the margin rate is 25%, A can buy 1,000 share of company X.
As A does not have the money to take delivery of the 1,000 shares, he has to cover his purchase transaction by placing a sell order by end of the settlement cycle. Suppose the price of company X rises to R440 before the end of the settlement cycle, A’s profit is R40,000 (40*1000). But if the same thing happened with his investment by means of taking delivery of 250 shares, he could have made a profit of only R10,000 (40*250).
But, the risk is that if the price falls during the settlement cycle, A will still be forced to cover the transaction and the loss would be adjusted against his margin amount. For instance, by the end of the settlement cycle, if the price comes down to R380, then the loss will be R20,000 (20*1000).
Let us suppose A does not have shares in his demat account and he wants to sell X's shares as he expects the prices of share to go down. He can sell the shares and give the margin to his broker at the applicable rate. As he does not have the shares to deliver, he will have to cover his sell transaction by placing a buy order before the end of the settlement