Business | Investment
Margin trading may be new panacea
With the recent carnage in the UAE stock markets, the whispers within the brokerage community are getting louder. Many of us are awaiting the new baby - margin trading - to pull us from the current burrow.
- By Vyas Jayabhanu, Special to Gulf News
- Published: 23:32 September 26, 2008
With the recent carnage in the UAE stock markets, the whispers within the brokerage community are getting louder. Many of us are awaiting the new baby - margin trading - to pull us from the current burrow.
Like every newborn, margin trading has gone through the conceptualisation stage and is now ready for take-off.
In my several interactions with officials from the Emirates Securities and Commodities Authority (Esca) recently, the flavour of the discussion has been invariably margin trading. The regulator is convinced that this is the right time to introduce this globally-favourite sophisticated instrument in the UAE.
The broker community is privy to the fact that Esca had margin trading in its books for quite some time, the only delay was in its implementation. The authorities were waiting for the market to mature and iron out its vices before they introduced this facility.
World over, margin trading is widely used. Even in India and other neighbouring countries, margin trading is very much in vogue and the volumes are building up every quarter.
Margin trading? What's that and how will it bring cheer to our stock markets, you might ask. Margin trading is basically transacting using borrowed money. This borrowed sum, of course, bears a charge or usage fee and has a timeframe related to the transaction.
The power of leverage is a practical example of margin in action.
An investor deposits Dh10,000 into his margin-approved ABC Brokerage account and decides to purchase shares of XYZ company. Normally, he would be limited to the Dh10,000 cash he has at his disposal. Utilising margin trading, however, he borrows the maximum amount allowable (Dh10,000 in this case), giving him a grand total of Dh20,000.
He uses the Dh20,000 to buy 1,333 shares of XYZ company at Dh15 each.
Scenario A
Say the price of the 1,333 XYZ shares rises to Dh20 per share. The market value of the portfolio becomes Dh26,660 (1,333 x Dh20).
The investor sells the stock, pays back the Dh10,000 margin loan and pockets Dh6,665 before interest and the selling commission.
Had he not utilised margin, this transaction would have only earned him a profit of Dh3,330 before commissions.
Scenario B
The value of XYZ shares falls to Dh10 each and the market value of the portfolio falls to Dh13,330 (Dh10 x 1,333). Dh10,000 of that is cash from the margin loan.
Had the investor not bought on margin, his loss would have been limited to Dh3,330. He would have also had the freedom to ignore the fall in market value if he believed the company was a bargain.
His use of margin, however, has turned his loss into Dh6,665 plus the commission on the forced sale of stock and the interest expense on the outstanding balance.
Thus the power of leverage can be effectively used to make your money earn more handsome returns for you, provided you believe in the high-risk high-returns principle.
As with all leveraged investments the potential for both amplified profits and losses exists.
In the US, the margin money requirement for equity is 50 per cent whereas for bonds it is 25 per cent. This has meant that the less brave investors who are not very happy with high-risk equity segment could find their comforts in the debt markets, albeit through margin trading.
The other rub-off effect of margin trading is the additional revenue stream it generates for banks. World over, historically, leading banks have jumped on to the margin trading bandwagon and enhanced their fee income. Of course these banks will have to link up their internet banking services with the broker's website, which in turn will be linked to the stock market website.
Considering that margin trading is a relatively new product, global data is very hard to come by. One thing is for sure that beyond individuals, margin trading has a profound impact on the entire broker community as well.
This is aptly illustrated from a scenario that emerged on January 22, 2008, in India where shares fell as much as 12.9 per cent as panicky investors sold amid margin calls on declining share portfolios and fears of a global downturn.
India's Sensex closed 875.4 points down at 16,729.94 and its two most valuable firms, Reliance Industries and state-run Oil and Natural Gas Corp led the market lower.
Margin calls, both by brokers to investors and by exchanges to brokers, added to the pressure, with brokers saying they were unable to trade until they paid their margin calls.
Eid is round the corner. Once we finish greeting all our dear ones and wish them good luck for the coming year, we should also wish our stock markets with "Happy Margin Trading".
- The author is Head of Al Dhafra Financial Brokerage, UAE.
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