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 might also risk it all. It's called margin trading. Is it worth it?

Read on to see just how margin trading works and whether it's the right strategy for you.

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 borrowed money, though interest does accrue. And the amount you owe grows until you pay off the entire sum.

Before you proceed, you must understand initial margin requirements and maintenance margin requirements. Federal Reserve Board sets the minimums, but each broker is different.

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

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.

TIP: 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.

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.

This is 50%, according to the Federal Reserve Board. But some brokers require more. What does that mean?

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

Here's an example:

You want to buy XYZ stock, which trades at $8 per share. You have $4,000 to invest. You could either:

  • Purchase 500 shares in cash
  • 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.

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 the maintenance margin requirements.

The Federal Reserve Board set this amount at 25% of the value of the security. Brokers can raise this amount, but they cannot allow any amount less than 25%.

Here's an Example:

  • $8,000 of XYZ stock
  • 50% on Margin (You Borrowed $4,000)
  • 25% Maintenance Margin

After purchasing your stock, the value drops to $7,000. The 25% maintenance margin means that you need to have 25% of the stock value in your account.

25% × $7,000 = $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.

Equity = Stock Value - Amount Borrowed

$7,000 - $4,000 = $3,000

Your equity needs to be greater than the maintenance margin amount. In this case, your $3,000 equity is more than than the margin amount of $1,750, so you can continue trading on margin.

IF you had a maintenance margin of 45%.

45% × $7,000 = $3,150

Because your margin amount $3,150 is now greater than your equity of $3,000, you must pay your broker the difference in order to continue trading. In this case, its just $150.

But if you took out thousands of dollars, the difference can add up. If you can't come up with the difference in equity, the lender has the right to sell your securities until you pay off the maintenance margin amount.

In the above 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 simply 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. 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: Not all stocks can be bought on margin. Risky stocks like IPOs and penny stocks usually aren't eligible. It also depends on the broker.

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 is risky, but there is an advantage - leverage. You can buy more stock than you could 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.

Consider:

You buy 100 shares of XYZ stock, which trades for $10. That's a total investment of $1,000.

Let's say there's a big news release containing good news about XYZ Company. This caused the stock to double to $20 per share.

100 shares X $20 each = $2000

You just made $1,000 on your initial investment

But what if you bought that stock on margin? With your $1,000, you could now purchase 200 shares.

When the stock rose to $20 a share, you could then cash in your investment.

200 shares X $20 each = $4000

You pay the broker the $2,000 loan and walk away with $2,000 in your pocket.

By purchasing on margin, you made an extra $1,000.

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

The Risks of Buying on Margin

If a stock does well, you might make more when buying on margin. 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 to proceed with caution and 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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How to Compare Online Stock Brokers

How to Choose a Stock Broker

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