What is margin trading?

Imagine an ace comes to you during a blackjack game. Of course, you want to increase the rate, but you are tight with cash. Fortunately, your friend offers you $ 50 and says that you can return them later. Tempting, isn’t it? If a good card goes, you have a chance to get a big win and give it to your friend $ 50, leaving the proceeds to yourself.

However, what if you lose? You will not only lose the initial bet amount, but you will still owe your friend $ 50. Cash loans in casinos are like gambling on steroids and the potential profit is high and at the same time your risks increase too.

Margin is a risky strategy that, if used properly, can bring huge profits. On the other hand, you can easily be left with nothing and lose all that you have invested. More dangerous than margin investing, there can only be margin investing without understanding how it works. With this guide, you will learn everything you need to know.

Margin trading allows you to purchase more securities than you normally would. To conduct margin transactions you will need to create a margin account. It differs from the standard cash account, the trade with the attraction of which occurs according to the principle of using the money in the account. A margin account can be part of a standard account opening agreement or regulated by a completely separate agreement.

You need to make an initial investment to open a margin account, the minimum amount of which is $ 2000, although some brokers request more. This fee is called the minimum margin. When the account is open and ready to work, you can take up to 50% of the value of the security. This part of the value that you transfer to a deposit is called the initial margin. It is important to know that you do not have to bring the margin to the full 50%. You can borrow less say 10 or 25%. However, it is also necessary to keep in mind that some brokers require depositing more than 50% of the purchase price.

You can hold your loan as long as you wish, provided that you comply with all obligations. First, when a security is sold through a margin account, the proceeds go to your broker to pay the loan until it is paid in full. Secondly, there is also a restrictive requirement, the so-called supporting margin – the minimum balance in the account, which you must maintain, so that the broker does not force you to invest large amounts of money or sell securities to pay off the loan debt. The term “margin call” applies in this situation.

Cash loans are not in vain. Unfortunately, marginal securities on the account are collateral for the loan. You will also have to pay interest on the loan. Interest will be charged from your account if you do not make a payment. Over time, the level of debt grows, since interest payments accumulate and do not play into your hands. As debt grows, so does interest on a loan, and so on.

Therefore, a purchase with a margin is mainly made for the purpose of short-term investment. The longer you hold the investment, the more revenue is needed to cover the costs. If you are investing on a margin basis, the ROI will be negative.

Not all securities are eligible for margin purchases. The Federal Reserve Board of Governors establishes which papers are suitable for margin transactions. According to the general rule, brokers will not allow buyers to purchase on a margin basis too small stocks, securities that are traded off-exchange, or IPO papers because of the current risks that accompany such papers. Private brokers may also decide not to carry out margin transactions involving certain securities, so it is necessary to clarify in advance the restrictions that apply to your margin account.

Suppose you made a deposit of $ 10,000 in your margin account. Since you invest 50% of the purchase price, this means that your purchasing power is $ 20,000. Then, in the case of buying securities worth $ 5,000, you still have $ 15,000, which is the sum of your purchasing power. You have enough funds to cover this transaction, you have not used your margin. You start borrowing only when you buy securities worth more than $ 10,000.

This brings us to the important conclusion that the purchasing power of a margin account changes daily, depending on the fluctuation of the value of the margin securities in the account. Next, we examine what happens during the rise or fall of securities.

It’s all about the so-called leverage. In the same way that companies borrow money to invest in projects, investors can get cash loans and increase the amount of capital they invest. Leverage increases profit at each stage of growth of the stock. If you make the right investment, margin can help dramatically increase profits.

An initial margin of 50% will allow you to buy twice as many shares as would be possible only if you withdraw cash from your account. It is easy to understand the mechanism of a significant increase in profits when using a margin account compared to trading exclusively for cash. What really matters is whether your assets go up or not. The debate over whether it is possible to systematically select winning stocks in the investment world will never stop. We will not speak here about the debates mentioned. Just emphasize that the margin really provides an opportunity to increase your profits.

It is best to give an example to demonstrate the power of leverage. Let’s imagine a situation in which we all would like to be – the one that turns into an extraordinary increase in income.

We will stick to the figures of the order of $ 20,000, this is the cost of the purchased securities, which consists of a $ 10,000 margin and $ 10,000 cash. The cost of the share of Cory s Tequila Co. is $ 100, and you anticipate a significant increase in perspective. Normally, you would be able to buy only 100 shares (100 x $ 100 = $ 10,000). Since you are investing at a margin, you can now buy 200 shares (200 x $ 100 = $ 20,000).

Then Cory s Tequila Co. get Jennifer Lopez as the face of an advertising campaign and the stock price soars by 25%. Your investment is now worth $ 25,000 (200 shares x $ 125), and you decide to cash it. After paying your broker $ 10,000, which made up your initial loan, you have $ 15,000 left, $ 5,000 of which is net profit. This is a 50 percent revenue, even though the stock rose only 25%. Keep in mind that in order to simplify the illustration of this transaction, we did not take into account commission and interest. Otherwise, these costs would be deducted from your profits.

In volatile markets, prices can fall very quickly. If the balance (the cost of securities minus the amount of debt to your broker) of your account falls below the supporting margin, the broker can make a so-called “margin call”. Margin Call forces the investor to either sell existing assets or add more cash to the account.

Here is how it works. Let’s say you buy securities for $ 20,000, borrowing $ 10,000 from your broker and depositing $ 10,000 on your own. If the market value of securities falls to $ 15,000, the balance in your account will decrease by $ 5,000, respectively ($ 15,000 to $ 10,000 = $ 5,000). Taking into account the requirement of maintaining 25% in the account, the capital in your account should be $ 3,750 (25% of $ 15,000 = $ 3,750). Thus, in this situation, you are safe, because the $ 5,000 in your account is more than the established supporting margin of $ 3,750. However, let’s assume that your broker requires you to maintain a 40% balance on your account instead of 25%. In this case, the figure of $ 5,000 in your account is less than the required supporting margin of $ 6,000 (40% of $ 15,000 = $ 6,000). As a result, the broker may call you with a margin call.

If for any reason you have not received a margin call notice, the broker has the right to sell your securities in order to achieve the required balance on the account above the supporting margin. Even worse is the fact that your broker may not be obliged to consult with you before selling. Under most marginal agreements, a firm can sell your securities without waiting for you to receive a margin call. You can’t even influence exactly which papers will be sold to cover a margin call.

For this reason, it is necessary that before investing you very carefully read the margin agreement of your broker. This agreement covers the conditions for maintaining a margin account, including the following provisions on how interest is accrued, your obligations to repay a loan and how the securities you acquired are the key to a loan.

As you already understood, margin accounts are risky and not suitable for all investors. Leverage is a double-edged sword as losses and profits increase equally. In fact, one of the definitions of risk is the degree of fluctuation in the price of an asset. As leverage enhances these fluctuations, by definition, the risk to your portfolio also increases.

Returning to our example of inflated profits, suppose that instead of taking off by 25%, our shares fell by 25%. Now your investment would be worth $ 15,000 (200 shares x $ 75). You sell paper, pay your broker $ 10,000 and stay with $ 5000. This is a 50 percent loss, plus commission and interest, which in a different scenario would be only 25%.

Do you think that a loss of 50% is bad news? It can get much worse. Margin buying is the only type of securities-based investment where you need to be prepared to lose more money than you have invested. A decline of 50% or even lower will mean more than a 100 percent loss for you, with a commission and interest on top of everything else.

When working with a cash account, there is always a chance that stocks are rehabilitated. If the fundamentals of the company do not change, you may need to wait for the situation to improve. If it is somehow comforting you, your losses are only potential losses, until you decide to sell the shares. However, as you remember, with a margin account, your broker can sell off your securities if their rate drops sharply. This means that your losses are fixed and you will not have a chance to benefit from possible future jumps in price.

If you are new to the investment business, then we strongly recommend that you stay away from margin. Even if you feel ready to participate in margin trading, remember that you don’t have to borrow all 50%. Anyway, only venture capital should be allocated for investments with margin – that is, the money that you can afford to lose.