Margins and the math

In case of margin trading, try not to fully use the trading limit given to you. The extra limit provided is like an unused arrow in your quiver.

V. K. Sharma        Print Edition: May 31, 2007

 The lure of big money has always thrown investors into the lap of margin trading. Whether it was during the good old days of the badla system or the present day derivative trading or margin trading in the cash segment, leveraged speculation has always found many takers.

Margin trading involves buying stocks by paying only part of the total price. The broker finances the balance, though the risk—or rewards—emanating from the transaction are all yours.

Similarly, derivative trading involves taking a bet on the future price of a stock. If you buy a call option, you are being bullish on the stock and expect it to rise. If you buy a put option, you are being bearish and expect the stock to fall. Of course, legendary investor Warren Buffett has described derivatives as weapons of mass destruction with good reason. When the call goes wrong, the investor is ruined.

However, seasoned investors like Rakesh Jhunjhunwala have used leveraging with aplomb. The key here is to leverage selectively and that too after doing your own research and when your confidence is high. And once you have gained sufficient altitude, it is good to reduce that leverage gradually or put a stop loss that prevents your profits from doing a vanishing act.

Margin trading is relatively simple. You are required to pay only 50% margin. For instance, if you want to buy 50 shares of Tech Mahindra, when the price is Rs 1,500, you would be required to pay only Rs 750 per share. So you pay only Rs 37,500 for 50 shares of Tech Mahindra. Now if the price falls, you have to pay for the marked to market (M-to-M) loss. If the price falls to Rs 500, you would have to pay Rs 12,500 (Rs 250 per share x 50 shares) as M-to-M loss. If your stock recovers to the original price, the amount taken as M-to-M loss will be returned. But the margin money will not be returned, even partially, till you sell the shares.

Now let us assume that you sell your 50 shares of Tech Mahindra for Rs 2,000 each in a month’s time. You gain Rs 25,000 (Rs 500 x 50 shares) on your investment of Rs 37,500, i.e. a return of 66.6%. Had you invested Rs 37,500 without availing margin funding, you could have bought only 25 shares and your profit would have been Rs 12,500 or 33.3%. So by going through the margin funding route, you doubled your returns on the capital. But this knife cuts both ways.

What if the prices had tumbled to Rs 1,000? Well, if you had taken funding, the loss would have been Rs 25,000. Had you put in Rs 37,500 without any funding, you would have purchased only 25 shares and your loss would have been Rs 12,500. While your gains can double, so can your losses.

You can also dabble in the futures and options market by paying only a fraction as margin. There are 154 stocks and two indices in the futures and options segment. Each stock has different lot sizes. Infosys has 100 shares in one lot, Allahabad Bank has 2,450 and Ballarpur Industries has 1,900. You can buy a future of any of these stocks and pay only about 15-25% of the transaction value. For instance, if you buy one future of Infosys of 100 shares when the share is trading at Rs 2,050, you need to pay only Rs 32,800 which is 16% of the transaction value (Rs 2,050 x 100 = Rs 2,05,000).

The risk management group of your broker will tell you what margins to pay. Remember that the margin requirements change at the end of each day and even during trading hours. The exchange has a very complex system of calculating margins. There are more than one kind of margin. The most important margin is the SPAN (Standard Portfolio Analysis of Risk) margin. SPAN uses 16 risk arrays to scan probable underlying market price changes and probable volatility changes for all contracts in a portfolio to determine the profit and loss.

This system recognises the various positions built in a single code as a portfolio. The impact of this would become clear when we take more than one trade. At the time of writing this was at 8.47% for the Nifty. For each stock it is different. This SPAN margin is also known as the initial margin (IM). There is also an exposure margin (EM).

While margin trading and futures trading requires margin, no margin is payable if you buy an option, be it a call or a put. The premium is all you have to pay. Irrespective of whether the market crashes or zooms up, you won’t be asked to furnish any more money.

However, if you go short on an option—that is, sell it without having bought it—you have to pay margin to cover for any change in the underlying stock or index.

Lastly, do not be fully leveraged at all times. If you have got a sanctioned margin funding limit of say Rs 20 lakh, or a similar limit in derivatives, do not use that limit to the hilt at all times. Keep that sanctioned limit as an unused arrow in your quiver. And use it when you are most confident about the market movement.

(By V. K. Sharma, Director and Head of Research, Anagram Securities)

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