What Is Margin Trading? How It Works, Examples, Benefits, Risks
If you’re testing the waters of stock trading, you may have come across the term “margin trading.” Many investors have tried it and made a lot of money, but just as many have lost everything they had invested. Add crypto to the mix, where prices are even more volatile, and you’ve got a recipe for disaster. Or success.
However, with proper understanding and risk management, this trading method can be a valuable tool for any trader and a great way to maximize your profits. So, how does it work? We’ll answer those questions and more in this article.
What Is Margin Trading?
Let’s start by explaining what margin is: Margin refers to the security collateral the investor must deposit before borrowing money from the broker for stock trading.
Similarly, trading on margin means using funds borrowed from the broker to buy shares or other securities. This is done in the hope that the purchased securities will go up in value, allowing the investor to sell them at a profit.
The purpose of this method of trading is to amplify the returns of successful investments. But it’s important to understand that it also amplifies losses. So, while it can be a very lucrative way to trade, it can also plunge you deep into the red if not managed properly.
How Does Trading on Margin Work?
To trade on margin, you must first open a margin account with a broker offering this option. You’ll be required to deposit an initial margin before you start. Once your account is opened and funded, you can begin trading.
When you want to buy a stock on margin, your broker essentially loans you the money needed to purchase a portion of the shares you’re buying. The shares themselves collateralize the loan. So, if the value of the stock goes down, you may be required to deposit more money or sell some of your shares to maintain the loan-to-value ratio set by the broker.
This is called a margin call - the term used to describe what happens when the value of your collateral falls below the margin requirement. If you don’t meet a day-trading margin call, your broker may sell some of your shares to cover the margin loan.
The loan you receive from your broker is called the margin loan. The interest rate on this loan is typically higher than the interest rate on a standard loan because it is considered to be a higher-risk investment.
The amount of money you can borrow from your broker is based on the margin requirement, which is set by the broker. The margin requirement is typically a percentage of the total value of the trade. For example, if the stock trading margin requirement is 50%, you can borrow up to $500 to buy $1,000 worth of stock.
There’s another restriction: the maintenance margin. It is the minimum amount of equity, i.e., cash, that must be maintained in a margin account. If the value of the securities in a margin account falls below the maintenance margin, the broker can issue a margin call and require the account holder to deposit more cash or sell some securities to bring the account back up to the minimum margin.
The Securities Investor Protection Corporation (SIPC) protects the net equity, i.e., the cash and securities owed to the investor by the broker, minus any indebtedness owed by the investor to the broker.
Note that margin trading is strictly regulated by the Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission (SEC), and the Federal Reserve. FINRA requires the traders’ maintenance margin not to fall below 25% of the current market value of the securities in their margin accounts.
Buying on Margin - An Example
To illustrate how margins work, here’s a margin trading example: Let’s say you want to buy $1,000 worth of XYZ Corporation’s stock. However, you only have $500 in your account. You can still make the purchase by borrowing the remaining $500 from your broker.
The loan is backed by the shares you’re purchasing. So, if the stock price falls, you’ll be asked to put in more money or sell some of your shares to stay within the value range set by your broker.
Assuming the value of the XYZ Corporation stock does not change, when you sell the shares, you will owe your broker the $500 margin loan plus any interest accrued.
This is when trading on margin can be a great way to amplify your returns. Namely, if the value of the shares goes up to $1,500, you will be able to sell the shares and repay the loan while also pocketing a $500 profit minus the interest on the margin loan.
Cryptocurrency and Buying on Margin
Buying cryptocurrency on margin is similar to traditional ways of trading. The main difference is that instead of borrowing money from a broker, you’re borrowing cryptocurrency from another user on a cryptocurrency exchange. There are numerous crypto exchanges offering this type of trading, such as Binance, eToro, Kraken, and Coinbase. Once you’ve opened an account on an exchange and deposited cryptocurrency into it, you can begin trading.
When margin trading cryptocurrency, you’re essentially using leverage to amplify your returns. The amount of leverage you can get will depend on your exchange. And with some, you’ll be allowed to borrow up to 100 times your account balance. This can be a great way to increase your profits, but it also comes with increased risk, considering the volatile nature of cryptocurrency prices.
The Advantages of Margin Trading
Now that we’ve covered the basics of selling and buying on margin, let’s take a look at some of its advantages.
You Can Trade With Less Money
When you trade on margin, you can purchase more shares than you could if you were only using the cash in your account because you're essentially borrowing money from your broker. This allows you to make bigger investments and potentially reap greater rewards. Capitalizing on leverage can be a great way to increase your returns.
You Can Be More Flexible
If you see an opportunity in the market, margin trading gives you the flexibility to act quickly and take advantage of it. With a cash account, you would have to wait until you had enough money to make the purchase. Also, more flexibility means more diversity in your portfolio, which can lead to greater rewards.
You Can Make Money in Both Rising and Falling Markets
With a margin account, you can profit from stock price increases and decreases. If the value of the stock goes down, you can hold onto it and wait for the price to rebound. Or, you can sell it and use the proceeds to repay your loan.
What Are the Risks?
Taking margin loans comes with a certain amount of risk. Here are some of the potential downsides involved in margin stock trading:
You Could Lose More Money Than You Invested
The biggest risk of margin trading is that you could lose more money than you invested. This is because you’re using leverage, which amplifies both your gains and losses. So, if the stock price falls, you could end up owing your broker more money than you originally invested.
Your Broker Could Force You to Sell
Another potential risk is that your broker could force you to sell your shares if the value of the stock falls below a maintenance level. This is known as margin call day trading, and it’s meant to protect the broker from losses. If you can’t come up with the money to cover margin calls, your broker will sell your shares to cover the loss.
The Account Fees and Interest Charges Can Be High
While margin accounts can offer great benefits, they also come with account fees and interest charges. Including a purchase fee, all these costs can add up quickly and eat into your profits, so it’s important to factor them into your decision-making process.
Margin Trading in Crypto Can Be Highly Volatile
When using cryptocurrency to trade, you should count on an even higher degree of risk due to the high leverage involved and the volatility of cryptocurrency prices. Using Bitcoin and other cryptos as collateral, traders can take out loans to buy more of the asset than they could with just their own cash. This can lead to greater profits if the price goes up, but it also amplifies losses if the price falls.
Experienced investors comfortable with higher risks can benefit from the margin in stock trading by using leverage to increase their buying power and potentially make bigger profits. However, it’s important to be aware of the risks involved, including the possibility of losing more money than you invest and being forced to sell your shares by your broker.
If you’re a novice trader, we recommend you steer clear of margin trading. There are plenty of other ways to get started in the market without taking on unnecessary risks.
What is the trading margin?
The trading margin, by definition, is the amount of money a trader must deposit to open a leveraged position. When trading forex on margin, you only need to deposit a small percentage of the total value of the trade to open a position.
This allows you to leverage your investment by borrowing money from your broker to finance the purchase, which can lead to greater profits if the trade goes in your favor. However, it also amplifies your losses if the trade goes against you.
What is margin trading with an example?
Suppose you have enough cash to buy $10,000 worth of securities. You can borrow another $10,000 from your broker and purchase $20,000 worth of securities. If the value of the securities rises by 25%, you’ll earn equity of $15,000 in total.
However, margin trading can lead to large losses, too. That’s why it’s only suitable for experienced investors comfortable with taking on higher risks.
What are the disadvantages of margin trading?
You should be aware of a few disadvantages to this trading method before you start. First, since it allows you to control a larger position than your actual investment, it also amplifies your losses if the trade goes against you.
Second, most brokers will require you to maintain a minimum balance in your account (known as the margin requirement). If the value of your account falls below this level, your broker may ask you to deposit more money or close out your position. Lastly, the fees associated with your margin account can eat into your profits.
For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.
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