Trading Stocks on Margin
Trading on margin allows investors to purchase more than they normally could. However, it also comes with inherent risks. Discover them with Queensway.
Margins & Stocks
This article will guide you through some of the procedures to trade stocks on margin. It will also recommend tips that could potentially benefit you when trading stocks on margin over the short-term.
Trading stocks on margin can be beneficial, depending on one’s understanding of what leveraged trading and trading on margin are and how to implement these in their strategy.
Unfortunately, it is not for everyone, and a new investor would need to cover quite extensive reading on how to invest in stocks and equities before deciding whether trading on margin is something that can be dealt with.
Margin trading is not a total gamble, but it does have its downside and upside risks.
Using margin to trade stocks means that you will borrow money from your broker to invest in the stock market.
If you are successful, you will be able to pay back what you borrowed and pocket the surplus as your profits. On the other hand, if your positions go against you, and you lose money, you will still have to pay back the money you borrowed in addition to the losses on your position.
When trading on margin, it is therefore important to make sure you have done your research thoroughly and are not reliant on share market tips alone.
Trading on margin is essentially based on borrowing money from your broker to purchase a higher amount of stocks than your trading capital would normally allow you to. To do this, you need to open a margin account with your broker. Usually, it is not possible to trade using a margin account with small amounts of capital.
A margin account usually requires a minimum of $2,000 as margin, and once all the paperwork is complete, you can then borrow up to 50% of the capital in the margin account. But keep in mind that each stockbroker has its own requirements. Keep looking and comparing the offers if you seek to trade with smaller amounts of money.
There is no restriction on paying back the loan immediately. However, whenever you sell stocks that you have purchased using your margin account, the broker will use the proceeds against the borrowed funds until they are paid off.
It is also crucial to keep a minimum amount in your account, which is used as maintenance margin – this is usually around 25%. Margin levels vary depending on the underlying asset’s volatility and liquidity.
Once again, it also depends on the broker. Just be sure you are aware of these margin requirements before you start trading. Your broker will also inform you when you have gone below the minimum margin and what amount you need to deposit to keep your positions open. This is called a margin call.
Another important point to remember is that the securities you intend to purchase through a margin account are used as collateral against your loan.
Moreover, margin accounts are not free of charge and, as an investor, you will have to pay interest on your loan. Hence, it would make more sense to use margin accounts for short-term investments, like day trading or scalping, as the costs of maintaining such accounts can quickly become expensive.
How does Trading on Margin Work? Real Examples
Take a hypothetical margin account opened with an initial $20,000 deposit.
As you are required to put up 50% of the cost of purchasing the stock, you have a $40,000 purchase potential. If you use $10,000 of this, you still can use a further $30,000. Don’t forget that you are borrowing money once the stocks you are purchasing exceed $20,000.
The purchasing power of your margin account is variable, as the market price of stocks changes minute by minute.
Continuing with our example…
You have purchased $40,000 worth of stock; half of the purchase price is your own funds and the other half is what you borrowed.
If the market value of the securities falls to $35,000, then the equity value in your account is $35,000 minus $20,000 = $15,000.
As part of the maintenance obligation of 25%, you are required to have at least $8,750 ($35,000 x 25% = $8,750), which means that you then have $15,000 equity in your account.
However, if the market value of your shares has dropped to $30,000, then your maintenance margin requirement is not 25% but 35%, meaning that you would have a requirement of $30,000 x 35% = $10,500, which is more than the equity in your account ($30,000 minus $20,000 = $10,000).
In this case, your broker will have to make what’s called a margin call of at least $500 to you, so you can keep your positions open. If you don’t comply with the margin call, the broker has the right to sell some of your stock without consulting you, to increase the equity in your account.
A Final Word
The biggest risk in buying stocks on margin is that your losses are magnified. When your loss represents more than 50% of the initial stock purchased, then you have lost part of the money you have borrowed; you could also lose all of your capital if the stock price keeps falling.
On the other hand, margin trading can be a powerful tool for investors looking to enhance their market exposure and magnify their profits, as margin accounts grant them access to greater sums of money to leverage their trading positions.
Margin trading is also a great diversification tool to create balanced short-term portfolios. With relatively small amounts of initial capital, an investor can invest in different assets with several positions, which can reduce the overall risk of the portfolio.