What is Margin Trading?
Did you know that there's a way to carry out trades with money that's borrowed? Margin trading1 allows you to do just that.
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In simple terms, margin means borrowing money from your brokerage by offering eligible securities as collateral. In more specific terms, margin refers to the collateral that an investor must deposit with their brokerage in order to cover the credit risk they pose. Investors generally use margin to enhance their buying power, so that they can purchase more stocks with the same amount of capital.
It's important to understand how trading on margin can be different from trading on a cash account. Typically, there are two kinds of non-registered brokerage accounts – cash and margin. With a cash account, it's your own money that is invested. With a margin account, you can buy a stock (or financial instruments) by borrowing the balance amount funds from a broker. When you borrow this money from a broker to purchase financial instruments, your own eligible securities serve as collateral.
Margin trading allows you to buy more than you would be able to normally – and while it can potentially maximize returns, it can also magnify losses. Another consideration to think about is the periodic interest you will need to pay to the broker for any money borrowed. If the interest rate is high, it could nullify any gains.
If you want to get started with margin trading, the first thing you need to do is get a margin account. Some brokerages may not permit buying on margin due to the risk involved.
Let's say you have $10,000 in cash. However, you think you've found a fabulous opportunity and want to buy $20,000 worth of a stock that trades at $100 a share.
You decided to put up $10,000 of your own money and borrow $10,000 from a brokerage. You purchase 200 shares and now own $20,000 worth of that stock.
If the stock goes from $100 to $120, that's a 20% increase on the purchase price. At that point, the 200 shares would be worth $24,000, and your account balance would reflect a total value of $14,000 ($24,000 in stock, minus the $10,000 margin loan). That's a 40% increase to your account value on only a 20% increase in the stock price.
Now, if the stock drops 20%, from $100 to $80, the 200 shares would be worth $16,000. Your account balance would reflect a total value of $6000 ($16,000 in stock, minus the $10,000 margin loan). That's a 40% decrease to your account value on only a 20% decrease in the stock price.
The loan collateral or the cash and securities in a brokerage account fluctuate constantly. If the brokerage has a maintenance level, a minimum level of cash and securities must be maintained in an account. This is to comply with terms of the margin loan. Now, if the securities in an account happen to dip in value, and the collateral falls below the maintenance level, the brokerage will issue a margin call. At that point, an investor can have anywhere from a few hours to a few days to bring the account value back up to the minimum maintenance level. This can be done by depositing money into the account, selling equities or closing option positions. Margin calls are usually based upon the total value of the account at market close. For most brokerages, the current market close time is 4 p.m. ET. In the event of a missed margin call deadline, the brokerage decides which stocks or investments to liquidate to bring the account back to the maintenance level. In times of extreme volatility, a brokerage firm may sell your securities to meet a margin call without any prior notice.
Before you use margin trading to increase your buying power, it's a good idea to understand the advantages and disadvantages of using this approach.
- More purchasing power: Even if you have a smaller amount to invest, margin can help to potentially boost your returns.
- More investing options: With a margin account, you can short a stock or try different stock option strategies.
- Tax deductible: Interest on margin loans may be tax deductible against your net investment income. However, it’s best to consult your tax advisor regarding your own situation.
- Trading flexibility: By trading on margin, you can take advantage of market opportunities in time or make adjustments to your investment strategy as long as you maintain the minimum equity required.
- Amplified losses: Moves that don't work out can rapidly impact the value of your investment. Even if you lose value, you are still required to repay your brokerage and you run the risk of losing more than your initial capital.
- Cost of borrowing: Your margin loan must be repaid with interest. Interest rates may fluctuate during your loan period.
- Margin call: Fail to meet a margin call and your brokerage may close-out the securities in your account without any notice. When this happens, you may lose the securities held as collateral and in addition, you may still have to pay your brokerage for all or part of the original margin loan. This also means that you cannot hold onto securities even if you feel they might rebound.
If you are new to investing, it may not be. While it may offer greater profit potential, there is also the risk of amplifying your losses. In the event of a margin call, you may have to liquidate your position or add more capital to keep your investments. It is important to assess your risk tolerance and only invest based on what you can afford to lose.
The fact that there is potential for both gains and losses to be amplified makes margin trading risky. That's why it may not be suitable for all investors.
Not all securities are marginable. Eligible stocks can be held on margin for as long as you like, provided you fulfill your obligations, such as paying interest on time and maintaining the minimum margin requirements.
When you use your margin account to buy and sell a security on the same business day, it qualifies as a day trade. This also holds true if you execute a short sale and cover your position within the same day.
With margin trading, you borrow cash from your brokerage to buy securities. You also pay margin interest on the loan. With short selling, you borrow securities from your brokerage to sell them for a profit when the value of a stock goes down. This strategy involves rebuying and replacing the borrowed stocks at a lower price. In both cases, you are borrowing from your brokerage and need a margin account.
Trading on margin allows investors to borrow against eligible investments. While margin may offer greater profit potential, investors also need to consider the risk of amplified losses and borrowing costs associated with margin loans. It is important for investors to understand their risk tolerance and trade within it.