What is Margin Trading and how does it affect your account?
Margin trading is a way of investing and trading with borrowed money, also known as using leverage. When you trade with margin, you’re borrowing money from your broker in order to buy securities. To put it simply, you’re using the lender’s money to buy assets that you think will appreciate in value.
Before we dive into whether or not trading on margin is a good idea for you, let’s talk more about how it works.
How does margin trading work?
The amount that you can borrow is called your margin requirement-this is based on the percentage of the stock price that the broker will lend you. For example, if the stock costs $100 and your margin requirement is 50 percent, then your broker will lend you $50 (half of the stock price). This means that with $50 of your own money plus $50 from your broker ($100 total), you can buy one share of stock worth $100. The initial margin requirement is put in place to ensure that you won’t lose more money than you have in your account.
When you make a profit, you pay back the loan from the broker, plus interest. If you make a loss, the broker will ask for the missing money.
How can margin trading help you?
You can use margin trading to:
- Buy securities that might otherwise be out of reach for someone if trading or investing with smaller capital.
- Diversify your portfolio by spreading out your investments over more securities than you could otherwise afford.
- Hedge your portfolio by making an investment that offsets a loss in another investment.
- Take advantage of short-term opportunities that may not be available again later.
- Magnify the gains by increasing the buying power on a high confidence trade setup in a good market environment.
What are the risks of margin trading?
Margin accounts are very risky and are meant for experienced traders. If you have a margin account, you’re agreeing to abide by specific regulations that could lead to your account being liquidated if your losses exceed your trade limit. In other words, along with giving you increased exposure to the markets, trading with a margin also increases your exposure to risk. If your trade moves against you and you do not have sufficient funds in your account to cover it, the broker may liquidate all or part of your position on your behalf, unless you are able to put up more funds or collateral. This is known as a margin call and happens in order to protect the broker from losses on the money they lent.
When should you trade with margin?
- You have a proven track record of making profitable trades. Even professional traders lose money sometimes, but if you’ve got years of successful trading under your belt and know what you’re doing, using margin could help you maximize the gains from each trade.
- You understand the risks. So that you can predict how much risk you’ll take on with each trade.
- You are prepared to cover any losses that may occur.
- The market volatility is low and the market is on a confirmed trend.
- Your broker offers competitive interest rates and low minimum requirements for opening a margin account. This way, you won’t spend all your profits on interest payments!
When not to trade with margin?
- If you’re just starting out with trading then stay away from trading with margin until you have mastered risk management.
- If market volatility is high and uncertainty is high, then it might not be the time for margin trading.
- If your recent track record shows that losses outweigh your gains, it’s probably better to avoid using margin till you are able to make your gains bigger than the losses.
- If your broker charges very high interest rates or if they have a high minimum requirement.
It’s hard to get your head around the concept of margin and leverage when you’re just starting out. It can seem like a scary and dangerous thing, but in reality, it is a powerful tool if you use it wisely. But it can equally hurt if used without proper experience and knowledge. It is always best to consult with your financial advisor before you start using margin. And one should always with small margins and build up from there once one gains experience.
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