I knew a senior citizen who had kept his money in many companies as fixed deposit. This is a story which happened long back – many of these companies are no longer accepting fixed deposits (so please do not ask me about it now). The companies were Tata Finance, Hdfc, Cholamandalam, Sriram Transport, Sundaram Finance, Lloyds Finance, CRB Capital, Viswapriya Financial, and Fortis Financial.

I redeemed his fixed deposits in Sriram, Lloyds, Crb, Fortis, Viswapriya financial – immediately.

For the next 12 months all these companies worked fine. Which means he would NOT HAVE HAD A problem. He would have been 92 now…and all this must have happened about 15 years ago. He kept cribbing that NOTHING HAPPENED AND we need not have removed the money!

THAT IS THE PROBLEM WITH RISK. Just because you have taken a car insurance, you will NOT have an accident. Just because you have worn a seat belt it does not mean there will be an accident. I know of one young 23 year old girl killed in a BMW last week. She did not wear a seat belt. When you do not wear a seat belt the air bags do not open. Killed on the spot. Driver unhurt.

Please understand: Not taking precautions COULD cause a damage, but you will not get a PRIZE for taking a precaution. That is the problem with pure risk. It is a one or none game.

Same is true for leveraged trading. No. This is not investing. This is trading with a leverage. It involves borrowing money from a banker (through a broker) to buy a share. This is internationally called a Margin account.

It allows you to use someone else’s money to buy more shares than what you could have bought on your own. So if you are a person with Rs. 20 lakhs net worth, and want to invest Rs. 10L and you go to a broker, he tells you – Why don’t you do a leverage (aka Futures n Options). He tells you that with Rs. 10L and with a 20 times leverage, you can do transactions worth Rs. 2 crores. Wow. You feel great, right? You need balls of steel of course. Leveraging creates a much higher profit potential than just trading with your Rs. 10L. So let us say your broker has bought shares worth Rs.2 crores and the shares go up by 5% in one month. Wow it means you earned Rs. 10L in one month. So the mind calculates…on Rs. 10L you will earn Rs. 1.2 crores a year..so ..LOL!!!

What the broker does not tell you is that margin trading MAGNIFIES the impact of losses. Also if there is a fall say of 5% – your whole margin of Rs. 10L will be wiped out. So what will the broker do? He would have already sold off the shares. He cannot afford to wait longer – UNLESS of course you pay the margin!! Remember you had only Rs 10 L. End of story. Your journey to the share market was just ended. Good bye.

Suppose you have Rs. 100,000 in your margin account, but you want to buy shares that cost more than that. Your broker has a 50% initial margin requirement, meaning you must pay upfront at least half the cash for a share purchase. This requirement gives you the ability to purchase up to Rs 200,000 worth of shares, effectively doubling your buying power.

After you make the purchase, you own Rs 200,000 in shares and you owe your broker Rs 100,000. The value of the share becomes the collateral for the loan he has given you. Obviously you will not be allowed to take the shares away unless you pay him. If the shares increase in value to Rs. 400,000 you sell it, you keep the shares after paying the broker the amount due to him along with the interest due on that amount. Normally it is a banker who does the funding, and rarely the broker. He may not have enough money to fund all the traders in his client list. Had you initially paid for the entire Rs. 200,000 yourself and sold at Rs. 400,000, your gain is only 50%. This shows how the leverage by purchasing on margin INCREASES gains.

Leverage amplifies losses in the same way. Suppose the stock price decreases to Rs 150,000 and you sell it to prevent further losses. After paying your broker the Rs. 100,000 your proceeds come to Rs 50,000. Your loss is about 50%, however if you had not leveraged, this price fall would have resulted only in a 25% loss.

Another risk of purchasing stocks on margin is the margin call. Depending on your past behavior and your broker’s rules (and SEBI rules) you will have to maintain a margin of say 50% always! So your broker will call you when the share price falls – he will call you and ask you to better the margins. You will have to pay the losses ASAP .