Genuinely, margin trading occurs when an investor borrows money to purchase stock. However, it is a high-risk trading method in which you put cash in a brokerage account as security for a loan and pay interest on the borrowed funds. Thus, should you include margin trading in your investment strategy? In this article, you can begin by learning about the benefits, risks and how to handle the margin trading. As a result, you may trade more confidently.
List of Contents
What Exactly Is Margin Trading?
Buying on margin is another term for margin trading. It enables you to increase your purchasing power. In other words, it makes larger purchases than you could with your funds. However, you have to remember that when you trade with borrowed money, you will face the danger of incurring more significant losses. Importantly, when you open a new brokerage account, you may be given the option of opening a margin account. This brokerage account allows you to deposit and borrow more money to buy investments.
In addition, a kind of secured lending is margin trading. When you borrow money from your broker to buy on margin, the loan is backed by the investments you purchase. It is similar to how a home equity line of credit (HELOC) is secured. Regulations allow investors to borrow up to 50% of the buying price of an investment. Your broker may impose restrictions on how much you can borrow for margin trading.
For example, suppose you open a margin account and deposit $5,000 in cash. Your broker would allow you to purchase $10,000. You must remember that if you are in stock margin trading, you will be charged an annual interest rate on the margin loan. Notably, margin trading interest is generally added to the monthly margin balance. When you sell your stock, the revenues are applied to the margin loan first, then to the account owner.
Nevertheless, if you are in CFD trading, you can join margin trading without paying an annual interest rate. However, your should keep in mind that your portfolio will stop out faster.
Working Principles of Margin Trading
The Federal Reserve, the Financial Industry Regulatory Authority (FINRA), and the Securities and Exchange Commission all rigorously monitor margin trading (SEC). While each broker has restrictions, the following are the general guidelines for all margin trading.
Minimum Margin
It is the basic minimum required to purchase securities on margin. Investors must deposit at least $2,000 or 100% of the purchase price of margin securities, whichever is smaller. Your broker may require a higher minimum margin deposit.
Initial Margin
When purchasing securities on margin, the percentage of the initial purchase price is covered by your cash. Regulation T of the Federal Reserve permits investors to borrow up to 50% of the original purchase price of stocks, while some brokers may require a higher initial margin.
Maintenance Margin
When you own securities on margin, you must keep a certain amount of your funds in your margin account. The least required maintenance is 25%, but it can be as high as 40%, depending on the broker. This principle ensures that investors do not go into too much debt.
For example, suppose you open a margin account and deposit $2,000 to meet the minimum margin requirement. Under the original margin guidelines, you could buy $4,000 worth of shares in this margin account. If the value of your $4,000 stock investment fell to $3,000 for any reason, a broker with a 40% maintenance margin requirement would issue a margin call and demand you to deposit an additional $800 in cash into your account.
Benefits of Margin Trading
Leverage
The primary benefit of margin trading is increased purchasing power. Genuinely, you can only buy assets using a cash account if you have enough money to cover the total transaction price. When you buy on margin, you can own more of them than if you only use your own money.
Flexibility
Unlike other types of loans, Margin accounts do not have set repayment schedules. As long as you meet the broker’s maintenance margin criteria, you only have to return the loan when the stock is sold.
Magnifies Profits
Margin trading using leverage can increase your potential profits and give you more options for buying on margin. This is because the value of securities rises; not only are the securities you own worth more, but their increased value as collateral provides you with more leverage for margin trading.
Risks of Margin Trading
Increased Losses
This is the inverse of the previously mentioned increased earnings. If the value of the assets purchased on margin falls swiftly, you will lose your investment and owe the broker money for the loan.
Margin Calls
If the value of the assets in your margin account falls below the minimum maintenance requirement, you will be subject to a margin call. A margin call occurs when the money in a margin account is insufficient to meet the required maintenance margin. When this happens, the broker demands the account holder deposit sufficient funds to meet the maintenance margin, which may result in a financial crisis.
Interest
Margin trading is not always accessible. You will have to pay interest on funds borrowed from your broker when you trade stocks. Nevertheless, the interest rate varies by the broker and is determined by both the amount borrowed and market conditions. The interest rates on margin always range from 4.75% to 12%. You must pay interest regardless of how well or poorly your investments perform.
Violent Liquidation
If your broker issues a margin call and you do not deposit enough cash by the deadline, the broker may liquidate the assets purchased on margin. This might happen without your knowledge and could cost you a lot of money.
Tips for Successful Margin Trading
You can take the following tips to reduce risks and boost your chances of profiting from margin trading.
1. Borrow less than the maximum allowed.
Generally, even if you have more capital, it does not mean you should waste it by buying every asset on the market. The best thing that you should do is to start with tiny investments. With time, you will earn the confidence and expertise to invest in riskier but more profitable assets.
2. Borrow just on a short-term basis.
A margin loan in stock is similar to any other type of loan. The margin account holder must pay a monthly interest charge, like a mortgage or auto loan. The longer it takes to repay the loan and the more the amount borrowed, the higher the interest expense.
3. Make reasonable investments.
The general guideline is never to invest money you cannot afford to lose. Margin trading increases the possibility of compounded losses. For example, if you borrow $1,000 to buy $2,000 worth of assets, you must recognize that any losses will be multiplied by two. Thus, you should only invest if you have enough funds to withstand a momentary move against their position.
Conclusion
To summarize, margin trading allows investors to improve their purchasing power by putting more money into the stock market. Nevertheless, it is riskier than other types of trading. As a result, when purchasing on margin, an investor should consider caution. You should not invest funds you cannot afford to repay if things go wrong. Similarly, it would be best if you prepared for unforeseen events such as a margin call. However, if done correctly, margin trading has various advantages, including the opportunity to diversify an investment portfolio.
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Source: Forbes