To be a margin trader means to use funds you lend from a broker. This way, you trade assets with borrowed funds. The asset in question then becomes the collateral for that loan that you took from your broker.

This has great potential to significantly increase the profit. However, it is also quite possible for it to cause incredible losses. Creating a financial leverage is a well known two-edged sword in the world of finances.

Due to the high-risk nature of this line of trading, it is only possible by use of margin accounts. But, let’s take it slow and go one step at a time.

What is Margin Trading?

In very general terms a margin is a border, an edge of something. However, in the financial world, the word margin has a slightly different meaning. Namely, the margin, in this case, is related to the collateral we have mentioned previously. The margin is used to cover the credit risk the margin trader poses for the lender. Essentially, it is the sum of money that you would have to ensure from your funds. The margin can vary greatly, which usually depends on the resource in question. For an example, a margin for currency futures is usually quite low. In fact, it would rarely get over 6 percent of the total value of the contract. However, if stocks were in question they would require quite a bit more. To be a bit more precise, you would usually have to cover at least 30 percent of the value and up to one half of it. One should bear in mind that the margin requirement will always follow the stock and how volatile it is. The more volatile the stock in question is, the higher the requirement will be.

Margin Accounts

Since margin traders accept the risk that comes with it, they must use a special type of an account. These margin accounts are quite different from the usual cash accounts. Margin accounts are usually offered by brokerages to create a possibility for the investor to borrow funds which he can then use to purchase securities. They always expect the investor to put down a certain amount before borrowing the rest. This is usually 50%. The broker will, of course, charge for the service in question and the securities are a collateral. The main difference between a margin account and a cash account is that you cannot short sell with cash accounts. Also, certain instruments can only be traded in them. For an example, futures and commodities.

The Risks of Margin Trading

Margin trading is definitely one of the riskier businesses out there. For that reason, there are multiple entities monitoring it and governing it. The Federal Reserve Board, Financial Industry Regulatory Authority, and even self-regulatory organizations (for an example – stock exchanges) as well as every single brokerage company.

For example, the New York Stock Exchange follows the margin debt sum. And, as of the 11/2017, the debt was almost 560 billion dollars. Of course, this does not come as a surprise. After all, almost every single equity index was at an all-time high or near it. It is relatively common to see margin debt follow market peaks. However, those who follow the movement of the market over longer periods are worried. They can compel investors to sell their assets to cover their margin calls which worsens the drop of stock prices. This pressure can cause complete market crashes.

Consensus: Leave it to the pros

We can all agree that this form of trading is definitely not something you would recommend to a beginner. It is a smart choice to leave it to traders with experience and those who are familiar with the risks. Even if the leverage can significantly increase your gains. If you do not have the experience one needs for a margin trader, you should stick to long-term investments.

1.Rate risk and interest charges

Every margin account has a rather high-interest rate. Over time, the interest cost on your margin debt can add up. This occurrence can make your gains on margined securities significantly smaller, as it can erode them. Another thing that’s important to know is the fact that interest rates on margin debt aren’t fixed. These can fluctuate during the period when you (the investor) have margin debt. In this environment where the interest rate is rising, margin loan interest rates will go even higher. In the end, this will add to the interest burden for every investor that’s engaged in margin trading. That’s why you need to pay close attention to interest rates if you don’t want them to “eat” your gains.

2. Amplified losses risk

Margin trade can increase gains, but unfortunately, it can also increase losses. We’ll explain how is it can happen to lose over 100% of what you initially invested during margin trading.
So, for instance, you invest $10,000 without a margin and buy 100 stocks at $100 each. If shares fall to $50 after six months, your stocks will be worth $50 dollars each, and your share sale proceeds will be $5,000. This way, you only lose 50% of your initial investment. Not great, but you’re not in the red yet.
On the other hand, if you made a margin investment of $10,000 on those same $100 stocks, and bought 200 shares, you’ll lose a lot more. If shares fall to $50 after six months, your share sale proceeds will be $10,000, the interest on margin loan that’s 8.5% will amount to $425. In the end, you won’t just lose your entire investment. You will be in debt to your brokerage for another $425, or another 4.25%.
Even worse, if the security you bought takes a plunge and drops to zero instead of 50, the loss comes to $20,425. Your investment return would be minus two hundred and four percent. In the worst case scenario like this, you wouldn’t just lose your entire investment; you would also have to repay your $10,000 margin loan as well as the interest that’s $425.
If you owe to your broker, you need to repay it in full, as this debt binds you just like a debt to a bank or any other institution.

3. Margin call

If you bought stock on margin, and it suddenly has a sharp plunge (or if you were short selling, if that stock suddenly peaks in price), you’ll have to meet the margin call. This is the point where you’ll have two choices. Either to provide a lot of money or some marginable security at a very short notice. That’s why you need to have a backup at all times.

4. Forced selling

If you are unable to meet the margin call, your brokerage is able and it will sell those margined stocks without notifying you. If the market’s plunging, a forced liquidation like this might mean that your position will be sold at most unfavorable moment possible. This can generate a serious loss. Even worse, if those margined stocks eventually recover, all of this would’ve been for nothing. Unnecessary whipsawing.

Category: Margin Trading (page 1 of 1)

Learn to Trade: Margin Trading