Trading Strategies for Margin Trading: How to Maintain a Buffer to Avoid Margin Calls

Margin trading has gained significant traction among investors in India, offering the potential to amplify returns by leveraging borrowed funds. While it presents an attractive opportunity to boost portfolio growth, it also brings with it heightened risks that require careful consideration. With most brokers across the country providing margin trading services, understanding this facility is crucial.

In this article, we will discuss the margin trading facility or MTF in detail, along with exploring its features, benefits and risks.

What is Margin Trading?

Margin trading allows investors to borrow money from their broker to buy more securities than they could with their own cash. It helps increase purchasing power and aims to amplify potential profits. However, it also carries the risk of larger losses if the market doesn’t perform as expected.

For example, you have ₹1000, but you want to buy shares worth ₹2000. Well, you have various alternatives, but the most convenient option would be if your broker can loan you ₹1000 which you can repay later when you sell it.

While MTF increases your buying capacity, it comes with an interest charge on the borrowed amount which varies depending on the broker. However, it’s important to note that borrowing comes with an interest cost. The rate of interest varies across brokers. And that’s exactly what Margin trading facility or MTF is.

So before using MTF, it’s crucial to understand the associated risks and costs.

Margin Trading Strategies

Margin is a double edged sword which can strengthen both profits and risks. To use it effectively consider these margin trading strategies.

1. Start Small – Begin with Caution

Starting small is key when using the MTF facility. Don’t go all in at once. Understand how minor changes in price or quantity affect your return. Develop a clear plan for how you want to carry out your trade or investment.

Also, be cautious during the various cycles of the market. While the market may currently be in a bullish phase such conditions cannot last forever. When the sentiment turns bearish, your return strategies might take a different turn. So, start small and proceed with caution.

2. Be Disciplined – Align Your Strategy with Objectives

Let’s say you want to buy Reliance stock you don’t have to buy 100% of the stock using MTF. You might choose a trading strategy where you buy just 10% of the stock using MTF. This helps you slightly amplify your returns without excessively increasing risk. However, it’s important to have a disciplined approach. Set clear objectives for your trading strategy, such as how much extra risk you are willing to take and how much extra return you’re expecting.

3. Be Prepared – Research Before Trading

Avoid the misconception that the stock market always goes up or that only stocks with better financials will perform well in the long run. So, before buying any stock and leveraging using MTF, do your research to understand the business fundamentals and use margin trading only when you are confident in your analysis and have formulated a disciplined trading strategy.

4. The Art of Stop Loss and Take Profit Orders

If you can master stop loss and take profit orders, you are likely to do well with MTF. Let’s understand them one by one.

• Stop Loss Order – Protects against losses by automatically exiting a trade if the stock price falls below a predetermined level. For instance, buying a stock at ₹200 with a stop loss at ₹180 will limit your loss if the price drops below ₹180.
• Take Profit Order – Locks in profits by selling the stock automatically when it reaches your target price. For example, setting a take profit at ₹250 ensures gains are booked if the stock price reaches this level.

5. Avoiding Emotional Decisions in Trading

One of the key differentiators between successful traders and those who are struggling with the Margin Trading Facility or MTF is emotional control. Here are a few examples of emotional decision mistakes you might make.

• Overconfidence – After making a profit, some investors become overconfident, believing their success is due to skill rather than market conditions or luck. This can lead to dangerous trading decisions and, ultimately, to significant losses.
• Revenge Trading – In an attempt to recover your loss by overtrading which again worsens the situation. A disciplined trading strategy can help keep emotional decisions in check.

6. Don’t Try to Reverse a Failed Trade

Imagine you’ve taken a trade, but the market moves unfavourably and you incur a significant loss. In the heat of the moment, your emotions may prompt you to make rash decisions to recover your losses. This is where emotional control often falters. Most likely, in this scenario, your losses will become even more severe.

7. Beware of Margin Calls

When you use MTF, you need to put up a margin upfront, usually 10 to 20% of the buying price. But what happens if the stock price falls? You might face what’s called a margin call.
A margin call occurs when your broker requires you to deposit additional cash or securities to cover potential losses. If the stock’s price falls and your margin balance drops below a certain threshold, the broker will issue this call. Failing to meet the call may result in the broker liquidating your holdings to recover the loaned amount.

How to Maintain a Buffer to Avoid Margin Calls

When trading on margin, it’s crucial to have a buffer to avoid margin calls. If the stock price falls and your margin drops below a certain threshold, your broker may ask you to deposit more funds. To prevent this, consider the following strategies.

• Maintain Extra Funds– Always keep additional funds in your brokerage account. By maintaining a financial cushion, you can promptly meet margin requirements even if the market moves unfavourably.
• Monitor Margin Levels– Regularly track your margin levels and the performance of your holdings. Proactive monitoring helps you identify potential risks early and take corrective action before the losses escalate.

How Does Margin Trading Work?

Margin Trading Facility allows investors to purchase stocks with only a portion of their money as margin, while the remaining amount is covered by the broker. You may have noticed the term MTF (Margin Trading Facility) in your broker’s app. Let’s understand what it means and how the whole process works.

1. Initial Investment – MTF allows for long term investments, hence, the margin requirement is higher and varies across brokers. For instance, if you wish to buy a stock priced at ₹100 and the margin requirement is 25%, you need to pay ₹25 as your initial investment, while the broker covers the remaining ₹75.
2. Interest Charges – The broker’s contribution, i.e., 75% in this example, is essentially a loan and interest is charged on this amount. The interest rate typically ranges between 8 to 10% per annum, depending on the broker and market conditions.
3. Repayment – Suppose you sell the stock after a year for ₹120. Assuming an interest rate of 12% per annum, you would pay approximately ₹9 as interest on the borrowed ₹75. After repaying the loan and interest, the remaining amount, ₹37, will be credited to your account.

Advantages of margin trading

Let’s talk about some of the benefits of margin trading.

• Increased Buying Power– MTF allows you to buy more stocks than you could with your available capital. This enables you to take bigger positions in stocks and benefit from price increases.
• Enhanced Returns – If the stock moves in your favour and the returns on your stock are higher than the interest charged on MTF, the investor’s overall return can improve significantly. As shown in the previous example, a mere return of 20% turned into 50% when margins were employed efficiently.
• Diversification Opportunities – With the help of MTF, you can diversify into various stocks which helps reduce unsystematic risk. Diversification lowers the risk in a portfolio while providing the same returns at a reduced level of risk.

Risks involved in margin trading

While margin trading may seem straightforward, it carries significant risks. Here are some risks of margin trading to consider.

• Amplified Losses – Margin magnifies both profit and loss. While a 20% profit can turn into 50% with leverage, a 20% loss can also grow into a 50% loss with leverage. So, it is better to use it with caution and strategic risk management.
• Margin Call – When the market moves in the opposite direction, the broker may raise a margin call if you have not maintained enough buffer in your brokerage account.
• Interest on MTF – The fund provided by brokers is a kind of loan which incurs interest. If the return on investment is less than the interest charged, then you end up losing money while using leverage. So, check interest before using MTF and ensure your ROI is more than the cost of borrowing.
• Forced Liquidation – The broker is authorised to liquidate your position if you fail to meet the margin call. This forced liquidation can cause a series of losses to investors as the position might be closed at unfavourable prices.
• Market Crisis – During significant market downturn events like COVID19 and the 2008 crisis, traders with very high leverage suffer greatly due to margin calls and forced liquidation, selling at a price which is much lower than their buying price.

SEBI regulations regarding margin trading

The Securities & Exchange Board of India (SEBI) has introduced new margin rules to enhance transparency, security, and investor protection in the stock market. Below is a detailed comparison of the new margin system with the old one:

1. Transfer of Pledged Shares

Under the new rules, shares are directly pledged to the clearing corporation (CDSL or NSDL), meaning investors now retain ownership of the shares in their Demat accounts. This ensures that corporate benefits (such as dividends or rights issues) are directly credited to the investor’s account, as the shares are not transferred to the broker’s account.

2. Upfront Margin Collection

One of the key changes is the requirement for brokers to collect margins from investors upfront for any buying or selling of shares. This ensures that investors have sufficient funds in their accounts before engaging in transactions, reducing the risk of defaults.

3. Power of Attorney (POA)

Under the new margin rules, brokers no longer require a Power of Attorney (POA) from investors. Previously, investors had to grant brokers authority to execute transactions on their behalf. This change aims to give investors greater control over their accounts.

4. Availing Margin

To avail of margin facilities, investors are now required to create a margin pledge separately. This means that investors need to pledge their securities with the broker to obtain margin loans, ensuring greater accountability and security.

5. Margin Loan

The new rules make it compulsory for investors to pay a minimum 20% upfront margin in the cash segment when availing a margin loan. This is a significant shift from the previous system where upfront margin collection was not mandatory.

6. Using Intraday Profit

Previously, investors could use intraday profits to make new positions within the same trading day. However, under the new system, investors will only be able to use these profits after T+2 days, once the shares are settled in their account. This is aimed at reducing speculative trading based on unrealized profits.

7. Demat Account Changes

In the old system, stocks moved to the broker’s account after the investor pledged their securities. Now, shares will remain in the investor’s Demat account, giving them more control and transparency over their holdings.

8. Broker’s Responsibility: Opening a Separate Demat Account

To implement these changes, brokers are required to open a separate Demat account called ‘TMCM – Client Securities Margin Pledge Account.’ This account will be used to pledge securities to the Clearing Corporation, ensuring proper margin collection.

9. Re-pledging to the Clearing Corporation

Once the securities are pledged in the separate Demat account, brokers are responsible for re-pledging these securities to the Clearing Corporation to obtain the required margins.

10. Custodianship of Securities

While brokers are considered custodians of securities, some have previously been found guilty of misusing client funds and collaterals. The new rules aim to address these concerns by ensuring more secure and transparent processes for margin collection and pledging.

Conclusion- Smart and Informed Margin Trading

Margin trading can be effective if approached with discipline and a well planned trading strategy. It amplifies both returns and risks. Some of the trading strategies include starting small and then scaling up and having a disciplined approach in applying your trading strategy. At the same time be cautious about the risks involved like margin call and forced liquidation.