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Margin trading: Are you into it?

May 25, 2006

Markets have plummeted over the past few days and various reasons for the decline have cropped up. Margin pressure is one amongst them. In this write-up, we try and explain margin trading, its impact on equity returns, the mechanics and how it leads to chaos. What is margin trading?
Margin trading, a leverage investment mechanism, is trading with borrowed funds/securities. Margin trading is a means of investing beyond one's means. It generally leads to overtrading and can, at times, enhance one's speculative tendencies. While trading with borrowed funds, the client is required to deposit initial margin (good faith deposit).

Margin trading can have amplifying impact on returns. Returns are enhanced if the stock price moves on the expected lines of the client. While if price move contrary to expectations, losses surmount.

Some examples...
Example 1: If client wishes to buy share worth Rs 100 but is left with only Rs 50 in his pocket, he borrows Rs 50 from his broker. If the price of the security moves up by 10%, leaving interest to be paid on the borrowed funds out of the analysis, the return for the investor will be 20% (table below). While if the stock price goes down by 10%, then the investor will lose 20%. Thus, it can be said that margin trading is a 'double-edged sword'.

Example 2: Suppose there are two investors - 'A' and 'B', both having invested Rs 100 in a portfolio with a similar return profile. Client 'A' used own funds only while client 'B' borrowed to the extent of 50% of the initial investment. The return for the investor under various return scenarios is as follows:

Own Vs borrowed money...
Particulars Investor 'A' Investor 'B'
Own money 100.0 100.0 50.0 50.0
Debt (at 15% interest) - - 50.0 50.0
Total 100.0 100.0 100.0 100.0
Return on portfolio 20.0% 10.0% 20.0% 10.0%
Return (Rs.) 20.0 10.0 20.0 10.0
Interest cost - - 7.5 7.5
Net profit 20.0 10.0 12.5 2.5
Return to investor 20.0% 10.0% 25.0% 5.0%
(Note: Composition of portfolio is 10 shares of 'X' at Rs 10 each.)

Going forward with the same example, if the value of portfolio changes, the impact of the same on returns for 'Investor B' will be as follows:

Impact of change in value of portfolio on the profitability
Owned
Funds
Margin
Debt
Cost of
portfolio
Value of
portfolio
Surplus after
repayment of debt
Profit/Loss Return
50 50 100 50 0 -50 -100%
50 50 100 60 10 -40 -80%
50 50 100 70 20 -30 -60%
50 50 100 80 30 -20 -40%
50 50 100 90 40 -10 -20%
50 50 100 100 50 0 0%
50 50 100 110 60 10 20%
50 50 100 120 70 20 40%
50 50 100 130 80 30 60%
50 50 100 140 90 40 80%
50 50 100 150 100 50 100%

If the return on the portfolio exceeds the rate of loan, then the investor stands to gain and vice versa. Also, the returns are differential for a portfolio at different level of margin (own funds). A lower margin along with volatility in value of the portfolio has a greater 'leverage effect'. This can be seen from the table given below:

Profitability at different level of margins
Particulars Extent of margin
  25% 50% 75%
Self financing 25 50 75
Loan at 10% 75 50 25
Total 100 100 100
Return on portfolio 20% 20% 20%
Profit (Rs) 20 20 20
Interest payable (Rs) 7.5 5 2.5
Net gain 12.5 15 17.5
Return 50.0% 30.0% 23.3%

The mechanism of margin trading: Client interested in margin trading are required to sign an agreement with the authorised intermediaries (broker) and decide about the terms of agreement like interest rate (margin rate), extent of margin and the rate of compounding. Consequently, a margin account is opened and the investor deposits the required initial margin with the broker. The broker, based on the directives of the investors, executes the purchase order and shares purchased are collateralized with the broker. In addition to the initial margin, the investor is required to keep minimum equity in the account. The equity here means the net value of portfolio (value of portfolio minus the value of the debt) This equity is a specified percentage of the total value of the portfolio and is called maintenance margin. Once the level of funds in the account falls below the maintenance margin (due to the fall in value of shares), the investor is called to bring upon the shortfall.

Extending the Example 2 (initial margin of 50% and maintenance margin of 25%), the investor purchases stocks worth Rs 100. Assuming that the value of the portfolio falls to Rs 60, the amount of equity reduces to Rs 10 (Rs 60 minus Rs 50). As per the terms with the broker, the value of maintenance margin was 25% i.e. Rs 15 (Rs 60 multiplied by 15%). Since the value of the portfolio has declined, the broker calls for additional margin. If the margin call is not obliged, the broker is authorised to sell the securities without the prior information of the investor. In some cases, where the value of the portfolio becomes nil, the broker sells the entire lot of stocks without informing the investor.

We will cover more aspects of margin trading as we go forward. But one thing is for sure. Equities are a risky asset class and volatility is the name of the game in the short-term. If one takes a long-term view on equities, without resorting to borrowing money to earn money, the relative return is likely to be higher than other asset class.

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