What is Margin Trading?
Margin trading is the act of borrowing funds from a broker with the aim of investing in financial securities. The purchased stock serves as collateral for the loan. The primary reason behind borrowing money is to gain more capital to invest and by extension, the potential for more profits.
The cost of the loan differs from one broker to another. Similarly, the margin loan rates vary. They can go as low as 1.6% or as high as 8%. The margin loan rate is established in line with the federal funds rate, so it varies over time.
Risks of Margin Trading
On the surface, the practice sounds pretty simple. However, in reality, margin trading is a sophisticated process that carries plenty of risks. As a result of the heightened risks associated with the trading method, it can only be performed in a special account referred to as a margin account. It is different from the ordinary cash account that most people are used to.
When purchasing stock, one can use either a margin or cash account. However, short sales can only be purchased using margin accounts. In the same way, certain financial securities such as commodities and futures are also paid for using margin accounts.
Some of the risks associated with margin trading are:
1. Amplified losses
It requires no explanation that margin trading can amplify an investor’s gains significantly. However, it can also intensify his losses. In fact, it is one of those trades where investors can end up losing more than what they initially invested.
Take the example of an individual who invests $11,000 in a particular stock that is to yield returns within one year. Unfortunately, things don’t turn out as expected and he incurs a loss of $11,467.50. It means that apart from losing the entire investment of $11,000, he also needs to pay his broker $467.50.
If the stock price hits zero instead of $50 within a period of six months, his total loss will increase to $22,467.50. Put simply, the trader must repay the initial margin loan of $11,000, as well as the interest charge of $467.50. Some traders think that being indebted to brokers is easier than dealing with banks or financial institutions. But in reality, this type of debt is just as binding as the one with banks.
2. Margin Call
A margin call is when a broker asks the trader to add more money into margin account until it reaches the required margin maintenance level. If the borrower has made too many losses because of underperforming securities, the margin account may go below a certain point. When it happens, the investor will need to sell some or all of the assets in the account or look for funds to cover the difference.
Depending on the terms stipulated in the margin loan agreement, a broker has the right to take action if the investor fails to live up to his promise. For example, if the investor is incapable of meeting the margin call or is only making losses, the brokerage firm or individual can decide to sell any remaining assets in the margin account. If the stock market is on a downward trend, the investor’s position will be sold at the worst time and generate considerable losses.
Practices for Successful Margin Trading
To minimize risks and increase the possibility of realizing gains from margin trading, consider the following:
1. Invest wisely
The rule of thumb here is that one should never invest a sum of money that he cannot afford to lose. Margin trading creates a risk of intensified losses. To illustrate this, consider an investor who borrows $1,000 to purchase $2,000 worth of stock. If the stock price decreases and the broker makes a margin call, the investor will have lost his entire investment, and then some.
2. Borrow less than the allowed limit
Just because an investor has access to more capital doesn’t mean that he should squander it by investing in every stock on the market. The best thing that the individual can do is to invest small amounts first. With time, he can build up his confidence and gain enough skills to invest in riskier but more rewarding stocks.
3. Borrow only for the short term
A margin loan is like any other loan. As is the case with a mortgage or a car loan, the margin account holder is required to pay a monthly interest charge. So, the longer he takes to pay the loan and the larger the sum of money borrowed, the higher the interest expense will be.
The Bottom Line
Margin trading enables investors to increase their purchasing power by providing more capital to invest in shares. However, it is riskier than other forms of trading. As such, an investor should tread carefully when he or she is buying on margin. For one, such a trader should not invest money that he cannot afford to pay back in case things go wrong.
Similarly, the investor should plan ahead for eventualities like a margin call. But, if it’s done efficiently, margin trading offers several benefits, such as the ability to diversify an investment portfolio and flexibility in repayments.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: