Margin trading refers to the practice of using borrowed money from a broker to invest.
Margin trading could amplify possible returns and losses on the investment.
Margin trading increases investors' buying power, but also involves higher risk and may trigger a margin call.
Understanding Margin Trading
Margin trading refers to the practice of using borrowed money from a broker to invest. The term margin refers to the amount deposited with a brokerage when borrowing money to buy securities.
When buying on margin, the investor uses the margin-able securities or cash in their brokerage account as collateral to secure the loan. The collateralized loan comes with an interest rate that will be calculated periodically and charged.
For instance, if the initial margin requirement of your broker for a certain stock is 60%, and you wish to purchase $10,000 worth of the stock, then your margin would be $6,000, and the broker could loan you the rest.
A margin account is needed if an investor wants to trade on margin. This is different from a regular cash account. A margin account is a standard brokerage account in which an investor is allowed to use the current cash or securities in their account as collateral for a loan.
Each brokerage would have different requirements to qualify for margin trading and different terms for its services. A brokerage can also set its own rules on interest rates and how much of your own money you must have in the account compared to borrowed money.
In margin trading, as the investor is using borrowed money, or leverage, both the losses and gains would be magnified as a result.
Pros and Cons
1. Increased Buying Power
The most obvious benefit of margin trading is that it increases an investor’s buying power. Margin trading allows you to borrow money, and therefore you can purchase more stock than you'd be able to normally with a cash account.
2. Higher Potential Returns
Increased buying power allows you to buy more securities than you could otherwise afford. The more securities you own, the greater your potential profit if those securities gain value.
1. Higher Risk
Borrowing money to invest is risky. There’s no guarantee that an investment will succeed. Whether the securities you buy gain or lose value, you will have to pay back the borrowed amount.
In some cases, you could wind up losing more money than was put into your portfolio.
2. Interest Charges
Borrowing money isn't free. When you use margin to invest, you have to pay interest based on the amount of money that you’re borrowing.
Before investing on margin, investors should take the cost of it into account. The interest charges reduce gains on successful investments and increase losses from poor-performing investments.
Even if the shares you buy maintain their value, the cost of borrowing money can lead to losses.
3. Initial Margin & Maintenance Margin Requirements
If you want to trade on margin, you first need to post a certain amount of cash, securities or other collateral, known as the initial margin requirement. The current initial margin requirement set by the Federal Reserve Board's Regulation T is 50%. However, some equity brokerage firms may set their initial margin requirement higher.
Once you trade on margin, enough value should be maintained in your margin account to meet the brokerage's maintenance margin requirement (or the margin call requirement), which is usually 25% according to the Federal Reserve Board's Regulation T.
If an investor's portfolio fails to meet the maintenance margin requirement, it could trigger a margin call, which may force the investor to either deposit additional funds or sell their investments.
Many investors fear margin calls as investors may be forced to sell positions at unfavorable prices.