Friday, February 15, 2013

How does margin trading work, the risks, charges and tax treatment in India

Introduction 

Margin trading is very popular with traders and anybody who thinks they can make a fast buck. It allows them to trade (buy/sell) in much larger quantities of the same stock than would be possible normally with cash/stocks in hand. In this article, we will focus on margin trading in shares (and not futures and options which we will discuss another time), the tax treatment of profits and losses, how much you can profit from it after all charges and fees involved, is the dice loaded in your favor or not, and what is the strategy you should adopt to avoid large losses.

What is margin trading in shares? 

Let us say a trader has Rs.2000. With this money, the trader can only buy five shares of a stock like Tata Steel at the price of 400 normally (in what is called the cash segment). To make any kind of profit the share has to move significantly within a day. With margin trading however, the broker (in this article the examples are all taken from ICICI Direct however most of the other brokers offer similar features and similar margins) will allow this trader to buy much more of the stock with that Rs 2000. Because the quantity bought is larger, the trader can make money with smaller price movements. How much more can the trader buy is something we will find out a little later. Basically, the broker is lending the remaining amount of money (in case of margin buying) with the stock you bought as collateral.

The same goes for selling. In margin trading, a trader need not even own the shares to sell it. Popularly known as short selling or shorting, a trader can sell Tata Steel without actually owning the stock and can buy it back later (squaring off the position). Brokers allow this too in margin trading. Of course, you can margin sell even when you own the stock, the fact that you own the stock may help you later to convert it into a real cash sell order and avoid losses if the stock went up from the price you bought. In this case, the broker is lending you the stock for selling with the cash you get from selling as collateral.

You would margin-buy if you expect the stock to go up and margin-sell if you expect the stock to go down.

The important thing to note here is that the broker expects you to pay back within the settlement period (within the same day for stocks in India). There are exceptions, some brokers give you some extra time to pay up provided you cough up interest and late payment charges. Sometimes if it is a margin buy order, you are also allowed to convert it to a regular delivery order and some give you additional days to pay up for such a conversion.

So if you bought more shares than you actually should have bought with your Rs 2000 in margin buying, then you are expected to sell those shares before trading closes for the day (or convert the order into a delivery order in which case you are supposed to have the money ready for paying up for the entire order - depending on the broker's rules you are supposed to pay up the entire amount within the stipulated days) . If you sold shares, then you are expected to buy them back before trading closes for the day (or convert it into a delivery order in which case you need to have those shares with you ready in your demat account for delivery or make suitable arrangements to deliver the stock). This is called "squaring off".

How does it work?

So to determine how many shares you can buy in margin (or sell), the broker works with several rules and conditions. If you and the stock you want to trade in meet all the conditions, then you are allowed to place the margin order. You or your stock price break any of the rules, your position will be squared off automatically (an order is placed without your consent to put it bluntly -- I am sure somewhere in the terms and conditions you would have been made to agree to this).

Most brokers allow margin trading in only a select list of stocks. Your broker will make this list available to you. They will usually pick stocks that have good volumes and are generally less volatile.

Margins - The reason why its called margin trading. There are two types of margins you need to keep with the broker. The initial margin (IM) is something you need to have with you prior to placing your order. The margin is a percentage of the trade value. So let's say you have Rs. 2000 and the IM% that your broker is offering on Tata Steel is 8% and the price of the stock is Rs 400. Now instead of the usual 4 shares you can now margin buy 62 Tata Steel shares (62*400*8% = Rs 1984). So the pre-conditions of having some trading money + able to meet the margin for buying 62 shares are met. The 8% margin is the broker's safety net calculated for that particular stock. It basically covers the risk of the share going down by 8%. The IM% is arrived at usually by looking at past data and is beyond the scope of this article. This margin also shows that you are serious about the trade (similar to  token deposits we leave with the landlord showing our intent of leasing the house/flat).

Now the moment you place this order, you will have to abide by three important rules.

a) Minimum Margin - You have to always maintain the second margin called Minimum Margin (MM) to meet any notional loss. Because share prices can be volatile, on a bad day, Tata Steel may vary beyond the 8% margin you have kept. The MM% makes sure that you always have some margin money kept with the broker to prevent losses that cannot be recuperated by the broker during square-off. Say the MM% is 4% and Tata Steel has gone below your purchase price of 400 by 4.25%. In this case your actual margin is now 8%-4.25%=3.75% which is below the minimum margin of 4%. To prevent your position from being automatically squared-off if you really think it will go up even from this fall of 4%, you will need to add additional margin money (some brokers may take the money you have allotted for equity trading in your brokerage account automatically if there is any money available there to safeguard your position).

b) You need to square-off your position before trading closes yourself

c) Convert your order into a delivery order. If you chose to convert it into a delivery order, you will usually pay different brokerage (as applicable to the cash segment), you will now have to pay in full for all of the 62 shares and the money so needed will have to be arranged for and paid to the broker within the broker's stipulated time + any interest charges and late payment charges if any.

If any one of the above rules is not met (you didn't maintain MM OR you didn't square-off  OR you didn't convert into delivery), the broker will square-off your position by placing a sell order on your behalf automatically. Sometimes, the position is not squared-off and  even when the above rules aren't met.

Your broker's rules and conditions may vary but the principle is basically the same. Some may give you upto 5 days to square-off the order  (what ICICI Direct calls the Client square-off mode) provided you have kept additional margin as stipulated by the broker and the buy order will be treated for brokerage purposes as a cash buy in this case.

It works similarly in a margin sell order except that to square-off you need to provide the securities from your demat account. Generally, margin sell orders must be squared-off on the same day of trade.

ICICI Direct usually compulsorily squares-off your open positions with 15 mins left for trade (3:15 PM if 3:30 PM is the close of trade).

Where is the catch?

Is margin trading is an easy way to make money? With your 2000, you bought 62 shares of Tata Steel because of margin trading. Tata Steel let us say went up by Rs.10 to 410 and you made Rs. 620 as your profit, right? Wrong. In all the examples that most people give you it is this simple math of (in our case) 410*62 - 400*62 = 620 profit. If you bought Tata Steel in the cash segment with your 2000, you would have only bought 5 shares and thus ended up with a Rs. 50 profit.  But, your profits sadly aren't 620 but a lot lesser.

What profits can you make after Charges and Fees?

Catch #1: A big portion of your profit is eaten up by the broker and statutory charges. 

We'll take a more realistic example. Let's say you had Rs 1 Lac as your margin capital. With 8% IM, you can buy about 3000 shares of Tata Steel at 400 on NSE. Let's say you sold it at 402. Here is your laundry list of charges assuming brokerage of 0.05%. You should have made a profit of 6000 if you took text book examples and even examples shown in the brokerage sites explaining the concept of margin trading. Here is the truth:

QuantityPriceTurnoverBrokerageTransaction chargesSEBI Turnover chargesSTT
3000.00402.001206000.00677.5342.011.21301.50
3000.00400.001200000.00674.1641.801.20
Gross Profit6000.00
Total Charges1739.40
Stamp duty50.00
Profit4210.60
Speculative income tax1263.18
Actual net profit2947.4249.12%

Buy charges
Buy side turnover is 3000*400 = 12,00,000 

Charge #1:Brokerage @ 0.05%*12,00,000 = 600
                 Service Tax @ 12.36% of brokerage = 74.16
Charge #2: NSE transaction charge @0.0031%*12,00,000 = 37.2 (it is higher at 0.0035% in BSE)
                  Service [email protected]% of transaction charge = 4.6
Charge #3: SEBI turnover [email protected] 0.0001%* 12,00,000 = 1.2

Sell side turnover is 3000*402= 12,06,000

Sell charges
Charge #1:Brokerage @ 0.05%*12,06,000 = 603
                 Service Tax @ 12.36% of brokerage = 74.53

Charge #2: NSE transaction charge @0.0031%*12,06,000 = 37.39
                  Service [email protected]% of transaction charge = 4.62
Charge #3: SEBI turnover [email protected] 0.0001%* 12,06,000 = 1.21
Charge #4: STT @ 0.025%* 12,06,000 = 301.5

Other charges
Stamp duty = 50

Note:- Brokerage is always charged on the total turnover, not on your margin amount. 

As you can see in the table above, from a gross profit of 6000, charges and brokerage has reduced it to 4210. So nearly 30% of your profits have been wiped out.

What is the Tax treatment for intra-day margin trading ?

Catch #2: Here comes the second catch or jolt. Intra-day trading where nothing comes or goes out of your demat account is considered (business) speculative income and depending on which tax consultant you ask is either charged at 30% flat rate OR at your tax slab.

So from 4210, you pay a further 1263 to the taxman leaving you with only 2947 as profit. That is nearly 50% of your so called profits just vanished into thin air.

The dice is not loaded in your favor

Catch #3:: Here's the third catch. Let's say someone did the exact same trade in reverse i.e. bought at 402 and sold at 400 (why you ask -- well the markets are never predictable and you can always be caught in the wrong side of the trend that day). What happens to this person? Are the losses the same here too at 4210. Sadly, no. See the table below, the losses for this person are at 7737. More than twice the amount.

QuantityPriceTurnoverBrokerageTransaction chargesSEBI Turnover chargesSTT
3000.00400.001200000.00674.1641.801.20300.00
3000.00402.001206000.00677.5342.011.21
Gross Profit-6000.00
Total Charges1737.90
Profit-7737.90

So, if you made the wrong kind of bet even though the differential was the same, your losses more than doubled.

Of course, depending on the price differential, the percentages will vary but in day trading you cannot play for a very wide spread the risk is too high so you keep the trades down to 2 or 3 rupees only in such counters.

How to avoid large losses?

As seen in the second example above, the losses mount up very quickly. If you are on the wrong side of the trade you can easily lose a lot even your entire capital on a really bad day. So how can we avoid such large losses?

a) Don't do margin trading. Period. Seriously. If you are a salaried person or anyone whose primary source of income is not the stock market don't do it. It's not worth it and you will only make losses in the long run.

b) If you must do margin trading (because its thrilling perhaps), use Benjamin Graham's prinicple. Keep a small percentage of your investible corpus aside as a speculative corpus. This could be say anywhere between 0.5% to 2% of your total corpus or whatever percentage it is that you are comfortable losing. Only use this to do margin trading OR in whatever speculative activity it is you want to indulge in including casino gambling, horse racing etc. Never add to this corpus. The day this corpus comes to zero, stop.

c) Stop losses. Keep strict stop losses. As seen above, the same 2 rupee differential on the other side will quickly make you lose 7% of your capital. So make sure you operate on tight stop losses and get out if the trade is not in your favor that day by taking a smaller loss than hoping for a turnaround later. Remember you only have a few hours to cover your trade. 

d) Place your bets..er..trades as early as possible in the trading day. This will give you enough time to cover, definitely avoid placing bets when there's just an hour of trade left unless you know absolutely what it is that you are doing.

Conclusion

We have tried to explain what margin trading is, how it works, what kind of profits you can make and more importantly the losses you are likely to incur and some strategies to avoid large losses. In our experience, margin trading and intraday trading in general is fraught with risk and not suitable for most retail investors but if you must try it out make sure you know what the product is all about and the risks before entering it.