Margin trading involves borrowing money from a brokerage to make trades. With this strategy, your account is provided extra credit to boost its trading value. As a result, every dollar in your margin account is worth more than they appear to be.
However, such a risky method best fits experienced investors willing to make their money as collateral for a loan and are fine paying the additional costs included in the borrowed funds.
Margin Trading Explained
Margin trading allows you to trade bigger positions even if you don’t have the necessary amount of money on hand. Also known as buying on a margin, margin trading helps increase your purchasing power by giving you access to leverage.
While the benefits of margin trading are pretty excellent, the part where you’re using leverage to ramp up your investments carries some serious risk.
Leverage is widely seen as a double-edged sword in this industry, meaning it can magnify your odds of making more money, but it also magnifies the risk of you losing more than you can tolerate.
Several brokerages offer investors the option to open a margin account, which lets them fund their accounts and then borrow more, preferably a larger amount of money, to purchase securities.
So if you take the margin trading route, you’ll be involved in a type of secured lending where you take out a loan from your broker to buy investments and later repay that loan. That loan is secured with the assets you invested in.
Repaying the loan usually includes an interest that is charged every month. When you sell an investment, the proceeds from that sale will pay down the margin loan. Meanwhile, the remainder can go to you.
When buying securities on a margin, investors are required to only borrow up to 50% of the security’s purchase price in compliance with regulations. In addition, brokerages may have their own limits on the amount or percentage you can borrow for margin trading.
Suitable Participants of Margin Trading
Margin trading is more suitable for experienced investors than beginner investors, considering the risks and costs involved with using this strategy. In fact, beginners should avoid participating in this type of trading as it is a risky approach that can result in detrimental losses.
If you want to do margin trading, the first thing you need to do is confirm whether you have enough money on hand to keep you on steady grounds.
You will also need a clear risk management policy should your margined securities lose value. Otherwise, your broker will have to liquidate your investments, causing you to incur a substantial financial loss.
Benefits of Margin Trading
As mentioned above, margin trading increases your purchasing power through leverage. Cash accounts can only get so far. They only provide access to securities that you can pay the full buy price. But when you buy on a margin, you can purchase more shares than you can with your investment money alone.
Raises Potential Profits
When the value of your margined securities climbs, their worth goes up, and so does their value as collateral. As a result, you receive extra leverage for margin trading. That process is how margin trading with leverage raises your potential profits. Thus, helping you find more opportunities for buying on a margin.
Margin trading offers some financial flexibility since margin accounts don’t follow a set repayment timeline. Instead, you only need to repay the loan when the security is sold. Provided that you maintained the broker’s required margin level.
Margin Trading Worst Case Scenario
Seeing the margined assets you’re holding lose value is perhaps the worst situation you may have to deal with in margin trading. That is because the assets you bought on a margin act as collateral. Thus, any price drops would weaken your equity and may lead to a margin call.
A margin call is triggered when the equity in your margin account is below the maintenance margin amount.
It is a request from your broker telling you to put more cash into your account, deposit unmargined securities, or sell your existing positions to stay on the required maintenance margin amount. Investors are usually given a deadline of two to five days to meet the call.
For example, you opened a margin account and funded it, let’s say $2,000, to meet the minimum margin. According to initial margin guidelines, you have the option to turn around and invest $4,000 in a stock in your margin account.
If that $4,000 investment declined to a $3,000 value, and the broker requires investors to maintain a margin of 40%, the broker would have to make a margin call. Thus, requiring you to put an additional $800 in cash in your account.
Factors to Consider in Margin Trading
Raises Potential Losses
As stated earlier, margin trading with leverage raises your potential profits. However, it also creates the possibility of you facing huge losses.
If the value of the assets you purchased on a margin fell sharply, you could end up with no equity investment and be left with only the loan that you need to pay your broker.
In margin trading, the money you borrowed from your broker will include an interest that you must pay. Whether your investments are performing well or poorly, you will have to pay the interest.
Margin interest rates vary depending on the amount you borrowed and market conditions. Typically, the rates range from around 4% to 12%.
A margin call will trigger if the value of your holdings in the margin account drops below the broker’s required maintenance margin. Should this happen to you, it’s imperative that you fund your account further as soon as possible. Specifically because you’re on a deadline.
Forced liquidation results from not meeting the maintenance margin requirement on time.
If you don’t have enough money in your account by the deadline, your broker has the right to liquidate the holding you acquired on margin. Forced liquidations can happen without the investors’ knowledge and even if it will leave them with considerable losses.