When you qualify for margin trading, you can borrow money to buy more stock using your existing stocks as collateral. It could theoretically boost your profits, but it comes with risks.
Margin Trading: Definitions and ExamplesWhen many traders want to purchase a stock, they either put the money into a brokerage account or save it up by collecting dividends, interest, and rent on their existing investments. However, "margin trading" is another option for purchasing stock. In its most basic form, Margin trading is when an investor borrows funds to purchase stocks. It usually works because your brokerage lends you money at a low-interest rate. In effect, you now have more purchasing power for stocks or other eligible securities than you would have with just cash. Your account and any assets you have in it are then used as collateral for the loan. Warning: Margin trading carries a much higher risk than traditional stock trading in a cash account. Experienced investors should only consider this strategy with a high-risk tolerance. The catch is that the brokerage isn't investing alongside you and isn't sharing any of the risks. The brokerage provides you with a loan. You will be held responsible for repaying the loan regardless of how the stock performs. Margin accounts come with a variety of terms and conditions, but you shouldn't expect to be able to set up payment plans or negotiate the terms of your debt. Your brokerage has the legal right to change the terms at any time, including the amount of equity you must maintain. A "margin call" occurs when you are required to increase the amount of money or securities in your account. If you don't have enough cash or stocks to cover the margin call quickly, the brokerage may sell securities in your account at its discretion. Unlike a margin account, a cash account requires investors to fund a transaction before it can be executed fully. When you use cash accounts, you won't get into debt and won't lose more than the money you put in.
Margin Trading: What Is It and Why Should You Do It?Margin trading necessitates the use of a margin account. This account is distinct from a "cash account," which is the account that most investors open when they first begin trading. All securities secure a margin loan in your margin account (e.g., stocks and bonds). If you don't deposit more money to meet a margin call, your broker may sell some or all of your assets until the required equity ratio is restored. The amount of maintenance required varies by broker. It is the proportion of your holdings' equity to the amount you owe. To put it another way, it's the amount of money you can borrow for every dollar you deposit. The brokerage firm reserves the right to change this at any time. The interest rate charged by your broker on margin loans is also subject to change. When trading on margin, you run the risk of losing more money than you put in. Any outstanding debt will be your legal responsibility to pay.
Scenario 1: Margin TradingConsider an investor who deposits $10,000 into a margin account that was previously empty. The company has a 50% maintenance requirement and currently charges 7% interest on loans less than $50,000. An investor decides to buy a company's stock. They would be limited to the $10,000 they had deposited in a cash account. However, they borrow the maximum amount allowed by margin debt, $10,000, giving them a total of $20,000 to invest. They spend nearly all of the money on 1,332 shares of the company, each worth $15. The stock price drops to $10 per share after you buy it. The portfolio is now worth $13,320 ($10 per share multiplied by 1,332 shares). Even though the stock's value has dropped, the investor is still required to repay the $10,000 borrowed through a margin loan.
The Issue With This SituationAside from the outstanding debt, this scenario has another serious issue. Only $3,320 of the stock value is the investor's equity after the $10,000 debt is deducted. As a result, the investor's equity is roughly 33% of the margin loan. The broker issues a margin call, requiring the investor to deposit at least $6,680 in cash or securities in order to restore their equity to the 50% maintenance requirement. This margin call has a 24-hour deadline. If they don't meet the maintenance requirement within that time frame, the broker will liquidate their holdings to pay off the margin loan's outstanding balance. The speculator's loss would have been limited to $3,330 if they had not purchased on margin and instead purchased the 666 shares they could afford with cash. They also wouldn't have to deal with the consequences of the loss. They could hold their position and wait for the stock price to rise again if they believed the stock price would bounce back. However, because the trader in this scenario purchased the stock on margin, they must either pay an additional $6,680 to reinstate the maintenance requirement and hope the stock recovers or sell the stock at a $6,680 loss (plus the interest expense on the outstanding balance).
2nd Scenario of Margin TradingThe stock price rises to $20 after purchasing 1,332 shares at $15. The portfolio is worth $26,640 at its current market value. The investor sells the stock, repays the $10,000 margin loan, and takes home $6,640 in profit (though interest on the margin loan is not included). This transaction would have only made a profit of $3,333 if the investor hadn't used margin to boost their purchasing power.
The Benefits and Drawbacks of Margin Trading
- You have the ability to purchase more than your bank account will allow.
- Investing borrowed funds could result in higher returns.
- It is possible to lose money.
- Rehypothecation is a possibility.
Explained AdvantagesCan purchase more than your bank account allows: Your cash account restricts your spending to the amount of money you have on hand. If you're interested in a particular investment, margin trading allows you to make a much larger investment. Investing borrowed funds could result in higher returns: The more stock you buy, the more money you can make. Margin trading boosts your profits.
Explaining the DrawbacksYou could lose money: If you borrow money to invest more money and that investment loses value, you're going to lose a lot more money than if you just used cash. Risk of rehypotheses: When a debtor uses the collateral from a debt agreement, this is known as rehypothecation. Your securities are all considered collateral in a margin account, and your brokerage may use them as collateral for its transactions and investments. A " collateral chain " is formed when a piece of collateral is used in multiple transactions; a "collateral chain" is formed, connecting more people to the same piece of collateral. Collateral chains increase the fragility of financial markets. If one of these transactions fails, it can set off a chain reaction that affects more people than the two parties involved in the transaction. Warning: If you don't cover significant losses on margin trading, you might end up bankrupt.
How to Increase Your Account MarginOpening a margin account is relatively simple if you meet the minimum cash requirements. The minimum margin is the term for this requirement. The Financial Industry Regulatory Authority (FINRA) has set a minimum margin of $2,000 as a starting point. Once you've met the minimum margin requirement, all you need to do is fill out the form to apply for a margin account. You can either create a new margin account or add margin trading to an existing brokerage account. The application process will most likely be the same in either case.
Important Points to Remember
- When you use your margin account assets as collateral, you borrow money from your brokerage to pay for stocks.
- When you are required to deposit cash or securities into your account, this is known as a margin call.
- The brokerage may sell your securities if you don't have enough cash or stocks to cover the margin call.
- Margin trading has the potential to make you more money, but it also comes with a lot of risks, including the possibility of losing more money than you put in.