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Margin trading: need to check price volatility

MARGIN TRADING is one the instruments available to investors for trading in the stock market. It is particularly useful in India at present when investors are getting used to transferring funds and making deliveries in the rolling settlement. It is critically linked to achieving an integration between banking and the securities market. While margin trading by itself may not pose any risk to the market, its tendency to contribute to volatility must be controlled with adequate checks and balances.

In margin trading in securities, a portion of the transaction value is borrowed and the securities so purchased are utilised as collateral. This leads to amplification of buying or selling of securities that have a greater value than the collateral.

A client normally deposits a margin as a percentage of the value of the transaction agreed upon. He either borrows funds for a purchase or the securities needed for a sale. Since money is borrowed, the client is able to do more trades than his own resources will allow and this leads to higher trading volume.

Trading in the derivatives segment is more than in the cash segment. Margin and derivatives trading being complement to rolling settlement, the latter will pave the way for active margin trading. Margin trading enables a client to make more profits if the market moves on expected lines but involves more losses if the expectations fail.

How does the margin trading system work in practice? For example, take two clients: one uses his own funds while the other uses 50 per cent of his own funds and borrows the balance. Each buys, say, 5,000 shares of company X at Rs.10 per share. The scenario will be as follows:

Client 1: The amount spent on buying 5,000 shares of Rs.10 is Rs. 50,000. If the price rises to Rs.11, the profit is Rs. 5,000 and the return on investment 10 per cent.

Client 2: Here, the return is around 20 per cent on his own investment subject to the deduction of interest on Rs. 25,000 borrowed.

It is seen that due to leverage, the second client gets a return of 20 per cent. However, there is a downside. There is the risk of a larger loss in margin trading. If the price falls to Rs. 9, the loss will be 20 per cent on own investment in the second case and 10 per cent in the first. Thus, there is a greater risk if the portfolio of securities of an investor is volatile in nature.

Any investor who wants to do margin trading is normally required to sign an agreement with the lender of funds. The agreement provides the terms of the margin trading, the extent of margin and other details. It normally covers two things — the initial margin and the maintenance margin. The initial margin is the amount paid by the investor to the lender before the actual purchase. After the agreement, an account is opened and the initial margin amount is deposited based on orders to be executed. The securities received from the margin will be used as collateral and the investor must maintain certain minimum value of the equity in the margin amount. The value is nothing but the value of the portfolio minus the debit.

Normally about 40 per cent is kept as margin in such cases and it is called maintenance margin. Once the equity value falls below the maintenance margin, the client has to replenish the margin; otherwise the shares kept as collateral will be sold in the market at the risk and responsibility of the client. If the margin call is not made, the lender can sell the collateral securities either partially or fully for the amount required for maintenance margin.

Risks involved

Margin trading involves risks for clients. Because of the amplification effect, if the market moves contrary to expectations, the client may lose money. It is also associated with the portfolio of shares that a client holds. If the portfolio itself is very volatile, leveraging it may bring in certain problems. Similarly, additional funds have to be brought in whenever the share prices come down and this has to be done at very short notice.

If such resources are not brought in, the lender may off load the securities either partially or fully to adjust for the debit in the account.

The lender faces less risk because the initial and maintenance margins and the right to sell the shares are in place and the agreements protect him. He recovers the amount immediately. However, the lender must have a proper risk management and surveillance system in his back office to make margin calls on time and sell the securities to avoid loss.

As for the market, while the lenders are fully protected by adequate collateral, there is a possibility of increased price volatility due to amplification. In a bull market, the value of the equity margin increases and it enables the investor to take more positions. This may lead to increase in price sometimes.

Similarly, in a falling market, the lender may liquidate the positions, accentuating the price falls. Such a situation can be controlled by securities lending in the case of a bull market and putting restrictions on short selling in the case of a falling market.

U.S. scenario

In the U.S., the Federal Reserve Board and self-regulatory organizations follow their own norms for margin trading. The clients are advised to pay the immediate margin before entering into trading. The client is allowed to borrow up top 50per cent of the purchase price of the securities and the clients can bring in 50 per cent, which is called initial margin. Similarly, maintenance margins are 25 per cent of the market value of the securities is insisted upon. A firm can also have higher maintenance margin depending on the securities. Similarly, the Securities Exchange Commission is not putting any restriction on their members for doing any fund-based activity. However, there is an upper limit, a member can provide towards debts depending on the capital of the firm.

Indian scenario

The Securities Contracts (Regulation) Rules, 1957 do not permit a member to take up any fund-based activity. It has been reiterated by the authorities that the business of funds lending cannot be a regular business activity of the members of the stock exchange. However, a member can lend or borrow money if it is incidental to securities transactions. Therefore, some members do margin trading, it is learnt.

On the recommendations of the RBI-SEBI Standing Technical Committee, certain guidelines were issued. The finance extended for margin trading must be within the overall 5 per cent exposure limit to the capital market.

The banks on the amount lent for trading must maintain 40 per cent margin and again it should be lent only for shares, which are in dematerialised form. The margin trading can be successful only if there is proper risk management and instantaneous funds transfer by the banks.

R. Pattabiraman

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