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When you trade derivatives like futures or options, margin money refers to the amount of money you deposit with the broker in order to open a position. This money is used as collateral to cover any potential losses that the trader may incur on the trade. The margin is given back to the trader after the trade is closed. In some cases, the margin requirement may be expressed as a percentage of the trade size. In this article, we will talk about margin money in the stock market, types of margins, and various aspects of it.
Table of Contents
Defining Margin Money
Margin is a useful tool for traders, as it allows them to open larger positions than they would be able to with just limited capital in their account. However, it also carries the risk of increased losses if the trade goes against the trader, as the trader will be required to deposit additional funds to maintain the position. Margin is the sum of money taken from a broker to pay for an investment, which is calculated as the difference between the investment’s entire value and the loan sum. Margin trading is the process of using money borrowed from a stockbroker to exchange a financial asset that serves as security for the broker’s loan.
Types of Margins
In the Indian financial market, there are four main types of margins:
Initial Margin
This is the margin that a trader must deposit when opening a position. The initial margin requirement is typically set by the exchange or the broker and is based on the risk involved in the trade.
Maintenance Margin
A margin call is issued by a broker when an investor or trader’s maintenance margin falls below an acceptable level. This is the minimum amount of margin that a trader must maintain in their account in order to keep the position open. If the pricing of the position falls below the maintenance margin level, the trader will be required to deposit additional funds in order to maintain the position. If the trader is unable to do so, the position may be closed by the broker. Both the initial margin and maintenance margin requirements may vary depending on the asset being traded and the broker’s risk management policies.
Margins Call
A broker will notify an investor or trader of a margin call if their maintenance margin falls below the acceptable level. In case you get a margin call, you need to put money into your account to stop your futures contracts from being liquidated automatically and subject to a fee.
Margin of Variation
You must top up your account when you get a margin call and your maintenance margin drops below the appropriate amount. The variation margin is the fluctuation in the original margin and the cash available.
Working of Margin Money
When the question ‘What is the margin money?’ arises in trading, the answer is that an investor must deposit some money in order to open a trade using leverage. Leverage allows traders to open positions that are larger than their account balance, which can enable them to potentially earn larger profits. It also increases the risk of losses since the trade is effectively being funded with borrowed money.
Here’s an example of how margin works: Suppose you have ₹10,000 in your account, and you want to trade a futures contract worth ₹50,000 that has a margin requirement of 10%. In that case, you will need to deposit 10% of the total value of the trade as a margin, or ₹5,000. This ₹5,000 will serve as collateral for the trade, and it will be used to cover any potential losses that you incur.
If you are successful and the trade increases in value, you can close the position and take your profits. However, if the trade moves against you and you incur a loss, the margin will be used to cover the loss. If the loss is larger than the amount of margin that you have available, your trade will be closed, and you will be required to add more margin to your account or deposit additional funds to maintain your position. Understand the risks and rewards of options trading in India before you start trading.
Disclaimer: It’s important to note that margins can vary depending on the asset being traded and the broker that you are using. Some assets and brokers may have a higher margin requirement, while others may have a lower requirement. It’s also worth noting that trading on margin carries a higher level of risk and may not be suitable for all investors.
Perks of Margin Money
Leverage
One of the main benefits of trading on margin is the ability to trade with leverage. This means that you can open a larger position than your account balance would normally allow, which can potentially allow you to earn larger profits.
Increased Buying Power
Margins allow you to potentially increase your buying power, which can enable you to take advantage of opportunities that may not be possible with your current account balance.
Ability to Trade with Less Capital
If you don’t have a large amount of capital to invest, trading on margin can allow you to get started in the market with less money upfront.
Potential for Higher Returns
Since you can trade with leverage, there is the potential for higher returns when you trade on margin. It’s important to keep in mind that higher returns also come with higher risk.
Opportunity to Earn Passive Income
Some traders use margins to open long-term positions that they hold for an extended period of time, with the goal of earning passive income.
It’s worth noting that while trading on margin can offer these advantages, it also carries a higher level of risk and may not be suitable for all investors. It’s important to carefully consider your financial situation and risk tolerance before deciding whether margin trading is right for you.
Risks of Trading with Margin Money
- Higher potential for losses: As it’s trading with leverage, there is the potential for larger losses in the case of trading using margin. Suppose the trade moves against the trader, and they incur a loss. Traders may be required to add more margin to the accounts or deposit additional funds to maintain positions.
- Risk of margin calls: A margin call occurs when the balance in an account falls below the required margin level. If this happens, the broker may automatically close an open position to bring the account back up to the required margin level. This can result in significant losses, especially if the trade is not stopped at a favourable price.
- Risk of bankruptcy: If trader losses exceed their account balance and they are unable to meet a margin call, they may be at risk of bankruptcy.
- Higher risk of emotional trading: Trading on margin can be emotionally challenging, as the potential for larger profits and losses can lead to impulsive decision-making. This can increase the risk of overtrading and making poor trade decisions.
It’s important to keep these risks in mind when considering whether to trade on margin. It’s also worth noting that margin trading is not suitable for all investors and may not be appropriate for your financial situation. A trader should always carefully consider risk tolerance and financial goals before deciding whether margin trading is right.