Traders should understand the difference between margin trading and trading with a cash account in order to make the best decision for their investment and trading goals. If you are looking to settle trades same day, then having a cash account is best, but if you are looking to increase your buying power as quickly as possible to trade on, a margin account is best.
What is Margin Trading?
Margin trading is when an investor borrows money from a brokerage to buy an asset. It is the difference between the borrowed amount from the broker and the total value of the assets held in the investor’s account. If you are borrowing on margin, then you are borrowing money from a brokerage to buy securities. The investor buys an asset with a smaller percentage of the asset’s value and borrows the rest from the brokerage. The broker is a lender and the securities in the trader’s account act as collateral.
Margin refers to the amount of equity in an investor’s account. To buy on margin is to borrow money to buy stocks. An investor has to be approved for a margin account in order to borrow money from the broker and not a regular brokerage account. A margin account allows the investor to buy more than he/she can with the balance in their account.
If traders use margin to buy securities, they are essentially using their current cash or securities which are already in their account as collateral. This loan also comes with a periodic interest rate that has to be paid. Since the investor uses leverage, his/her losses are maximized. This kind of choice by the investor is best undertaken when the investor expects a higher rate of return on the investment than the interest rate.
Buying on Margin
A brokerage account usually requires a minimum of $2,000 to open a margin account, though some may require more capital. By law, your brokerage should ask for your consent to open a margin account for you. Once a margin account is opened, a trader can borrow up to 50% of the price purchase of the stock but one can also borrow less like 10%, 20%, or 25%.
As long as a trader pays interest on the loan, the trader can keep the loan as long as he/she wants. When the investor sells stock on a margin account, the proceeds go to the broker for the repayment of the loan until it is fully paid. Investors should also understand the term maintenance margin, which means a trader should have a minimum amount in the account, otherwise the broker will ask for more deposits or the selling of stock to repay the loan.
A margin call is when the broker demands the investor to add more funds into the account or close out positions to remain at a stable level. A brokerage can do this on its own if the investor does not meet its requirements. The broker can also charge the investor a commission for doing this and investors are responsible. A margin call means that one or more of the securities held in the account falls below a certain point.
A margin call happens when the investor’s total equity value of equities falls below a certain percentage which is what maintenance margin means. The New York Stock Exchange requires investors to keep 25% of the total value of their securities as margin. Borrowing money does not come free, so investors and traders should take caution when they should do this, because debt can increase if interest is not paid on time.
How Does Margin Trading Work?
Margin trading has to do with how an investor trades, not what an investor trades, therefore more independent investors have more flexibility with trading. Traders though should take caution with margin trading because they can lose more than they bargained for in a short period of time.
Investors sign an agreement with the brokerage to open a margin account. From here, an investor makes a deposit into the account, a minimum of which is $2,000, that has been established by the Federal Reserve. From here, a trader can get a first margin loan. Let’s say a trader has $5,000 in his margin account and wants to borrow up to 50% allowed under Regulation T. In this situation, the trader can buy $10,000 worth of stock. The total is the $5,000 and the $5,000 borrowed from the brokerage.
A trader usually decides to buy on margin with an anticipation that the price of the stock will increase, and traders can also use margin to short a stock. Once a trader accumulates more margined stocks in their account, these can be used to ask for additional margin loans. A trader can use the value of the stocks as collateral instead of adding more cash into the account.
Advantages of Margin Trading
There are advantages to margin trading that investors should be aware of to see if these line up with their goals. First, investors who use margin trading do not tie up all of their capital to trade. This could result in a higher return on investment if their margin trading goes as planned.
For example, if a trader invests $5,000 in cash to buy 100 shares of a $50 stock and this stock increases in value by 50% within six months, your investment is now worth $7,500. When a trader invests on margin, the number of shares that can be bought increases by 200, which means a trader would double the investment to $15,000. The return on investment is magnified and the trader gains more with less capital on his/her part.
A lower capital allows the investor to be flexible and diversify his/her investments. Diversification helps to provide a sort of safety net against risk in the market. Keeping your money in various assets lets the money go farther in case one sector gets hit with a downtrend while another is in an uptrend. If a trader also has more cash, then this cash can be used when needed so that assets are not forced to be liquidated.
Disadvantages of Margin Trading
There are risks that should be considered when it comes to trading on margin. If, for instance, the stock that a trader decides to invest in sees a sharp decline in value, the trader could lose money more than the amount that was deposited into the margin account. Using the example from before, if the same stock sees a sharp decline in value of 75%, then the 200 shares bought on margin would now be worth $3,750. Your account could then end up being too low to the point where the brokerage sees the need to order a margin call.
The losing investment is not all that the investor would lose because there is also an interest to be paid on the margin loan. The amount of money that was used to borrow would have an interest that needed to be paid back. If a trader is not able to fulfill the margin call, the brokerage can sell all of the shares needed to pay back what is owed, which means a total loss to investment.
If there is a negative amount in the account after all this, the investor is responsible for paying whatever is owed. Brokerages can also increase the maintenance amount without notice which means the trader has to deposit more money into the account, or a margin call will be issued.
Minimizing Margin Trading Risks
Traders can lose money quickly with margin trading and newbie investors should take caution when thinking about this option. A trader can think of using margin trading as a short term trading strategy. It can help a trader maximize short term gains on a stock, while at the same time keeping the amount of interest paid on the margin loan to a minimum.
Also, do not invest all of the capital in a single or similar stock. Diversify as much as possible in different sectors or in ETF’s for an easier diversification. A margin trading strategy has to have defined risk. Each trader is different, so figure out what is the risk tolerance and set a higher maintenance margin to avoid margin calls. Each trader should also have a set amount that he/she is willing to lose. Cash and liquid investments should be set aside to handle margin calls and keep an eye out for the account regularly.
Margin trading is not an easy investment decision. It can help to streamline buying power for a potential move in the market, but it can also be a potential hazard in losing money quickly. By following a risk-averse strategy, a trader can minimize margin trading risks. If you also want to join like-minded individuals, take a look at RagingBull’s free webinar to go over the basics of trading.