Have you engaged in margin trading in the past or wish to do so in the future? If yes, then do you know how it impacts you and the stock market as a whole? Before we get into this discussion, let us understand the concept of margin trading in brief.
Margin trading is a day trading strategy that allows you to take large positions in the stock market. It allows you to purchase stocks that you cannot afford. You can buy stocks by paying margin money – a small amount of the actual stock value. The margin money can be paid in the form of cash or securities. Your broker provides the balance amount at a pre-determined interest rate.
You require a Demat, trading, and MTF(Margin Trade Financing) account to execute margin trades. You can open an online Demat account for free. The online Demat account application process is paperless and hassle-free. Demat meaning translates directly to “Dematerialization”. In other words, an online Demat account holds your securities in electronic or digital form. Now, let us understand how margin trading impacts stock market volatility in consecutive paragraphs.
Impact of margin trading on stock market fluctuations
1. Pyramiding and De-pyramiding effects
A pyramiding effect occurs when traders construe a bullish market trend as a continuous upswing in stock prices. This leads to higher leveraged buying or margin purchases which exerts more upward pressure on the stock prices. Consequently, traders may borrow more to fund the stock purchases.
De-pyramiding is the opposite of pyramiding, wherein traders believe that a bearish market trend implies a continuous fall in stock prices. This leads to large-scale margin calls by brokers and rapid selling by traders. Thus, the high selling activity pushes the stock price further down.
Thus, margin trading may lead to record price highs and lows in the stock market due to pyramiding and de-pyramiding effects, respectively.
3. Short sales
Markets are never 100% efficient. Thus, the stock price is never a true reflection of all information available. As a result, the outbreak of any news perceived to adversely impact stock markets leads to large-scale panic selling by stock traders and investors. This negative investor sentiment leads to a bearish phase in the stock market.
Margin traders may perceive this as an apt opportunity for short sales. Hence, they may leverage funds to buy stocks and sell them at market price, hoping to buy them back at a much lower price. Thus, margin trading leads to intermittent price rises due to increased buying activity amidst an overall negative price trend. In other words, margin funding-induced short sales cause significant disruptions in the stock market.
In a nutshell, information asymmetries and market inefficiencies might accelerate margin trading, thereby increasing stock market volatilities.
3. Stock valuation
Optimistic investors often believed that the stocks are undervalued, thereby leading to large margin purchases during economic booms. Similarly, pessimistic investors usually believe that stocks are overvalued, leading to large-scale selling or short sales during economic recessions.
However, this varied investor psychology impacts margin trading volumes which subsequently impact stock valuations. In fact, the higher the margin trading volume, the greater is the deviation of the stock price from its intrinsic value. Thus, margin trading may often lead to stock overvaluation or undervaluation.
Experts are divided on their opinions about the effect of margin trading on stock markets. While some believe that margin trading leads to increased market volatility, others believe just the opposite. They think that margin trading leads to stock price corrections and eventually stabilizes the market. However, with many financial leverage transactions remaining unrecorded, the true impact of margin trading on stock markets is still a matter of debate.