October 18, 2017

What is Margin Trading?

Read more about Stock Trading

Investing with borrowed money is risky business. You can leverage your profits, but you could also risk it all. It's called margin trading. Is it worth it? Are you able to give it a whirl?

Read on to see just how margin trading works and if it's something you should do.

The Basics

Margin trading is like investing with someone else's money. In this case, it's your broker's money. You can look at it like a loan. But it has stricter requirements. You aren't required to make monthly payments on the money borrowed. However, interest does accrue. The amount you owe continues to grow until you pay the amount off in full.

Generally, buying on margin is best reserved for short-term investments. The longer you borrow the money, the more money you'll owe in interest. This eventually takes away from your profits.

Before you proceed, you must understand initial margin requirements and maintenance margin requirements. We'll discuss the minimums set by the Federal Reserve Board. But each broker is different. Make sure you read the fine print and understand what your broker requires.

Understanding the terms is part of the battle. It's easy to get in over your head. Brokers don't take default on margin accounts lightly.

Minimum Balance Required

Before you can open a margin account with any broker, you'll need to meet the minimum margin. The absolute minimum is $2,000. Again, some brokers require more. Under no circumstances, however, can a broker lend to you on margin if you have less than $2,000 in your account. You can meet this requirement with cash or the value of your current securities.

The Initial Margin

It's not enough to have $2,000 in your broker account, though. You'll also have to meet the initial margin requirements. Right now, according to the Federal Reserve Board, the initial margin is 50%. This is, again, the minimum. Some brokers require more.

This means that you must have at least 50% of the amount of stock you purchase. Here's an example:

You want to buy XYZ stock, which trades at $8 per share. You have $4,000 to invest. You could purchase 500 shares in cash. You could also buy $8,000 worth of XYZ stock by putting $4,000 in your margin account. The broker would invest the $8,000 for you. This enables you to purchase 1,000 shares rather than 500.

You must have at least 50% of the value of the stocks purchased in your account in order to buy the stocks on margin.

This doesn't mean you have to borrow 50% of the stock you buy, though. You can borrow less. The maximum you can borrow, however, is 50% of the stock's value.

The Maintenance Margin

Once you meet the minimum or initial margin requirements, you have another requirement. It's called the maintenance margin requirements. The Federal Reserve Board set this amount at 25% of the value of the security. Again, brokers can raise this amount, but they cannot allow any amounts less than 25%.

Here's an example:

You purchase $8,000 of XYZ stock on margin. A month later, the value of the stock drops to $7,000. If the broker has a 25% maintenance margin requirement, you'll need 25% of $7,000 in your account. This means $1,750. Since the stock dropped to $7,000, you lost equity in the position. Your equity is the difference between the stock's value and the amount you borrowed. In this case, it's now $3,000 (you lost $1,000).

You owe the broker $8,000 and your investment is only worth $7,000 now. You have $3,000 in equity. This is still enough to cover a 25% maintenance margin.

What if, however, the broker required a maintenance margin of 45%? You'd then need a balance of $3,150 in your account (45% x $7,000). Since you only have equity of $3,000, you'd be in violation. The broker would issue a margin call. In other words, the broker requires that you fund your account with more money to reach the maintenance margin.

In this example, it probably wouldn't be hard to come up with the extra $150. But what if you had a margin call for thousands of dollars? You'd have to pony up the cash or liquidate your securities to pay off the debt. If you can't come up with the difference in equity, the lender has the right to sell your securities. They can do so until you reach the maintenance margin.

How to Buy on Margin

Buying on margin doesn't mean just opening an account with a broker. You have to be approved by the broker for margin trading.

It starts with signing a margin agreement form. Don't do this without reading the fine print, though. You must understand the interest rates and terms. It's just like signing for a car or house loan. You are putting up collateral in the form of your securities. If you don't meet the requirements, the broker has the right to sell your securities without your permission.

Once you accept the terms, you must meet the minimum margin requirement of $2,000 or the broker's requirements. After funding your account, you have the ability to buy on margin. Keep in mind that not all stocks can be bought on margin. Again, it depends on the broker. Risky stocks like IPOs and penny stocks usually aren't eligible for buying on margin, though.

Once you buy on margin, you'll have to watch your equity position. If your account falls below the maintenance margin, the broker can issue a margin call. Sometimes they give you time to fund the account back to its appropriate level. Other times, they'll just sell your securities until you reach that point. Again, read your agreement carefully!

The Benefits of Buying on Margin

Buying on margin sounds risky and it is, but there is an advantage - leverage. You can buy more stock when you buy on margin than you could when you buy with cash. For example, if a broker has a 50% initial margin requirement, you can buy twice as much stock. If the stock appreciates, you'll make a larger profit.

Here's an example:

You could buy 100 shares of XYZ stock, which trades for $10. You'd invest $1,000. Let's say there was a big news release containing good news about XYZ Company. This caused the stock to rise to $20 per share. You just made $1,000 on your investment.

What if, however, you bought stock on margin? Since you had $1,000, you could buy 200 shares. When the stock rose, you decided to cash in your investment. You cash out $4,000. You owe your broker $2,000 for the money they loaned you. You walk away with $2,000 in your pocket without putting out any more money on your own. If you didn't buy on margin, you could have let that $1,000 get away.

(For simplicity's sake, we didn't include interest or commissions in the example.)

The Risks of Buying on Margin

You might make more when buying on margin when a stock does well. But, when a stock does bad, you could end up in a dire situation.

Remember the maintenance margin? If you don't have enough to cover the maintenance margin when a stock price declines, you could be in trouble. The broker can sell your securities until you reach the required minimum. Not only do you lose when the stock price falls, but you lose your other securities as well. It's like a domino effect that has disastrous consequences.

The Bottom Line

Margin trading can be very profitable. It can also be devastating. You get higher buying power, but you stand to lose a lot if you aren't careful. Make sure you proceed with caution. Pay close attention to the terms. Also, keep margin trading for short-term investments.

More from CreditDonkey:

How to Invest in Stocks with Little Money

Common Investing Mistakes

How to Invest in Stocks

How to Invest in Stocks

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