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What Is Margin Trading?

Have you ever wondered about the nuances of margin trading? Margin trading makes it possible for investors to buy more stocks than they could afford otherwise by allowing them to borrow money from brokers. Margin trading can be very rewarding or end up costing you more than you planned. Understanding how margin trading works and whether the risks are worth it can help you determine if it’s right for you.

Key Takeaways

  • Margin is the money investors borrow from brokers to buy stocks with the goal of magnifying profit.
  • Brokers lend investors money and use securities and funds within the margin account as collateral.
  • Margin trading gives you more buying power than your cash alone would.
  • Margin trading magnifies the performance of a portfolio for better or worse.
  • Make sure to fully understand margin trading before investing with it. Even though it can boost your profits, it can also make your losses more extreme.

What Is Margin Trading?

Margin trading is more flexible than other types of trading because it deals with not what you trade but how you trade. Margin is the money investors borrow from brokers to buy stocks with the goal of magnifying their profit. Investors use the borrowed money to compound upon the money they already have available to invest in more stocks than their account would have originally allowed. Basically, it allows investors to borrow money from brokers to purchase stocks that were previously not in their price range.

Cash accounts only allow you to invest the amount of money available in your account. Margin accounts, on the other hand, use what is in your account (stocks, bonds, cash) as collateral against the money you have borrowed from the brokerage firm.

Understanding Margin

In order for fair trade, brokers lend investors money and use securities within the account as collateral. Margin trading is an easy way to make fast money. These loans give investors more buying power, allowing them to purchase larger amounts of stock than they could have previously, leading to a higher profit. Margin trading requires investors to make educated guesses on the movement of particular stocks in the hopes of increasing their profits while minimizing losses. While it can make you more money, it can also increase your losses if the stock drops.

Margin trading can be volatile. If the stock you’ve invested in is doing well, you could potentially double your profit because you’ve invested not just your money but also the money loaned to you. Instead of being able to buy only 15 shares, you could now buy 30. However, if the stock you’ve invested in drops, you could double your losses because instead of only losing the money you’ve invested, you’ve also lost the money you borrowed.

Using Margin Trading

To start investing with margin, you first need to open a margin account with a brokerage firm. Margin accounts are sort of like a mortgage for a home, but instead of a home, you’re buying stocks.

Margin accounts require a $2,000 minimum deposit. This is regulated and decided by the Board of Governors of the Federal Reserve System.

If you fail to equalize the account, the broker has the right to sell off any of the collateral within the account to balance the equity ratio.

There are a few things you need to know about margin accounts. The first is that brokers can change the terms of the account and sell any collateral in the account without warning. The second is that the broker isn’t sharing the investment with you, which means they don’t share the risks with you. If the stock does poorly, it lands on you to pay back the lost money.

Finally, margin accounts come with interest rates and requirements set by the brokerage firm. The firm holds the right to change requirements at any time. For example, they can change the minimum amount they require to be held within the account.

What Are the Advantages?

Margin trading can give you more money to invest than you have readily available in a cash account. It gives you more options on buying different shares of stock, therefore giving you more buying power. It allows you to expand your investments so you don’t have all your eggs in one basket, which could be helpful if one investment doesn’t perform as well as anticipated.

Margin trading allows investors to make money more quickly if the stocks they have invested in do well. This is obviously a big incentive to invest with a margin loan, but with every big risk, there can also be a big loss.

Image via Flickr by investmentzen

What Are the Risks?

Things can get ugly fast. If the stock does not perform as anticipated, the investor still has to pay back the borrowed money, which means they lose money. Since they borrowed money to begin with, they have to pay for both the loss of their personal money and the money that was lent to them through the margin loan. This can lead to debt and even bankruptcy.

The market conditions at any given time are also a risk. If the stock you invested in drops, you now have to pay back your money along with the loan, plus any interest you’ve incurred. You’ve now lost more than you invested. If you cannot pay back the loan, the broker will sell off collateral within the account without warning or your input.

The broker can also change the account requirements at any time, and you must observe the changes even if you’ve only just been informed about them. Also, if the brokerage issues a margin call, you cannot ask for time to get the money needed. You need to pay upfront, so it could be a good idea to have a separate account with extra savings just in case.

Real-World Examples

Time to examine some real-world examples. Let’s start with one where the stock does well. If you invest $500 and you ask for a margin loan of $500, you have a combined purchasing power of $1,000. You invest that $1,000 at $10 a share, giving you 100 shares. If the price of the stock increases to $20 a share, you now have $2,000. However, you have to pay the broker back the borrowed $500.

Once you deduct the $500 of your own money that you already invested, that leaves you with a $1,000 profit when you cash out your shares of the stock. Keep in mind that this example doesn’t include the interest on the borrowed $500.

Now, let’s see what happens when the stock doesn’t do well. The 100 shares you’ve invested in drop to $5 a share. This means the worth is only $500. You sell your shares and take the remaining $500 investment to pay back the $500 you borrowed from the broker before the stock can fall anymore. However, that means you lost the original $500 you personally invested, which leaves you at a loss of $500. This example also doesn’t include interest on the margin loan, which means you have actually lost more than $500.

If you’re optimistic, you could also hold on to your stock in the hopes that it would increase again. However, this could lead to your securities in the margin account being sold to equalize the balance of the loan.

If you had invested with a regular cash account, you would have had a profit of only $500 in the first example. You would make more money faster if you use a margin account. On the flip side, if you had used a cash account in the second example, you would have broken even because you wouldn’t have any interest to pay.

If you’re considering investing with a margin account, don’t dive in headfirst; talk to people who have done this type of trading before to make sure it’s a good option. Also, learn to keep close track of your accounts to try to minimize losses if a stock you’ve invested in drops in value.

M argin trading is a valuable tool to consider when investing. It offers a higher chance of making a profit, but it can also result in you losing more than anticipated if the stock drops. It’s a catch-22, so proceed with caution.