For example, if you were to buy 2000 shares of say Company A, which trades at Rs 300, you will need about Rs 6 lakh. But if you buy a future contract of that company, which comprises 2000 shares, you only need to pay a margin of 15 per cent. So by putting Rs 90,000, you can get an exposure of Rs 6 lakh.
The same operation can also be executed through margin trading. Here, the trader will buy 2,000 shares, which are partly funded by the broker, and the rest by the trader.
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The percentage of margin funding may range between 50-90 per cent, depending on the broker and his relationship with the client. The broker, in turn, funds his line of credit from a bank, and keeps the shares in his account with any profit/loss going to the client.
Margin trading vs futures
Most investors buy the futures, but there are times when margin trading makes mores sense. If a stock is not in the futures list, the client can go for margin funding.
Since futures are generally not available beyond one or two months, if the client has a longer view, then margin trading is better. Also, some brokers offer lower interest rates on margin trading than the prevalent rates in the futures market.
The margin call
Once the trader buys a future or stocks in the margin account, the client gets the profit/loss since his purchase in his account.
In both futures market and margin trading, if the value of the share falls below the purchase price, the broker will make margin calls, asking the client to deposit additional margin.
In a normal market, these margin calls are not a problem as clients can deposit the additional amount easily.
When clients are not able to meet the margin requirement, the broker sells the security so that he does not have to bear the risk in case the stock falls further.
This typically become a problem when the markets fall far more than expected and traders are not liquid enough to meet the margin calls. And when a lot of traders can't meet margin calls, the situation snowballs.
This is what happened in the past few days when traders, who were over-leveraged could not meet the margin calls, and their securities kept being sold.