Margin trading, Financial Management

Margin Trading:

Suppose an investor wants to buy 100 Reliance Energy shares, whose market price is Rs.500. This transaction requires Rs.50,000 but the investor has only Rs.30,000 as bank balance. He can approach a broker who will invest money on his behalf, taking interest for the same. Now he invests 50% of the amount (i.e., Rs.25,000) and the broker puts in the other half on his behalf and buys 100 Reliance shares in his name. Suppose maintenance margin is 40%, and if it falls below 30%, the broker has the right to sell the stock. Now the stock may fall to Rs.410, then the loss is Rs.90 per share. In this case, the loan from the broker is still Rs.25,000 but the investor's own account equity will fall to Rs.16,000. Now his maintenance margin equals 39.02% (Equity Account/Market Value of Holding x 100 i.e., 16,000/41,000 x 100). In this case the broker can ask him for the balance to take the margin to the 40% mark. He has to deposit (41,000 ´ 40% - 16,000) or Rs.400 to maintain the level of 40%.

Now, assume a market crash whereby the Reliance Energy shares fall to Rs.350. The margin loan still remains at what he originally took, i.e., Rs.25,000, but now his equity account falls to Rs.10,000. The maintenance margin has come down to only 28.57% (10,000/3,35,000 x 100). Thus, the investor can sell the shares and recover the balance amount when he is not able to fulfill the margin requirement that newly arose.

Posted Date: 9/10/2012 6:15:24 AM | Location : United States







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