In simplest of terms, margin trading refers to buying on borrowed money. Day traders and speculators, in particular, use this trading strategy to earn profits. However, qualifying for a margin account and the leverage limits with margin trading are difficult.
Traders and investors open margin accounts with broker houses. They deposit initial deposits and fulfill certain conditions to qualify for margin trading. Online brokers have made it easier to perform this trading with low initial investments.
What is Margin Trading?
Investors can buy stocks with cash by paying upfront including commissions. Long-term investors buy stocks with cash payments to the brokers. Day traders and speculators buy stocks with borrowed money in addition to their cash balances. Brokers lend money to traders in anticipation of closing transactions and making commission gains.
Margin accounts lending money to traders work similarly as loans. The traders make interest payments and other transaction fees. Brokers set the terms and conditions on margin accounts. Each broker house can make different qualification criteria to allow margin trading.
The leverage with margin trading also differs from the broker. Brokers can alter the terms and conditions of the margin account at any time. They also hold the power to invest your initial investment or lending it to other traders.
In the real world of stock markets, the potential of this trading can be substantially large. The SEC and other regulatory authorities regulate margin trading by setting limits. All stock markets set their regulatory rules for margin trading as well.
Important: Margin trading provides useful trading and liquidity benefits to all companies. Yet not every company allows margin trading on their stocks.
Margin Account, Minimum, Initial, and Maintenance Margin
Margin trading begins with opening a margin account with a broker firm. Opening a margin account with online brokers these days is not difficult. The brokers will verify the identity and income sources before approving your margin account.
The Securities Exchange Commission (SEC) and other regulatory authorities require certain conditions to meet with this trading. Significant conditions with this trading relate to the account margin requirements.
It is required by regulatory authorities to open a margin account. The SEC and FINRA require $2,000 as a minimum margin for a margin account.
As stock prices fluctuate several times during a trading day, the value of a trader’s investment changes. The FINRA and regulatory authorities require traders to maintain 25% of the total trade value as a maintenance margin. Brokers can demand higher maintenance margins from investors and it can range up to 30-40%.
If the market value of shares falls, their equity may fall below the maintenance margin levels. In that scenario, the brokers will issue a margin call to traders to deposit the required cash. Traders may opt to sell a few shares to settle the margin call as well.
The initial margin defines the maximum leverage allowed in stocks. Brokers can allow a maximum of 50% of leverage in margin trading.
Note: Maximum leverage limits in FOREX trading are different and can range up to 100 times of the transaction value.
It utilizes cash and borrowed funds. The investors deposited money with broker works as collateral to borrow more money. Brokers make a commission on trading and also charge margin interests by lending money to investors.
Traders open a margin account with an initial investment of $ 6,000 with a broker offering leverage of 50% and a maintenance margin of 30%. Let’s say the traders enter into a short-selling position. The trader uses the margin account to buy 200 shares of a company ABC priced at $60.
With a margin account, the trader can short 200 shares by investing only $ 6,000. If the trader speculated well and share prices fall to $55, he can make profits of $ 1,000 by closing the position ($60-$55 = $ 5 * 200). Without the margin, a trader’s profit would be only $500. Investors with long positions will make profits if the share prices appreciate.
If the share prices fall significantly below the maintenance margin, the broker may issue a margin call to the trader as well. In our example, if the equity value falls below $ 8,571 ($6,000 /1-30%) the broker can initiate a margin call. Or if the share prices fall below $ 42.85.
Risks with Margin Trading
This trading allows leverages buying of stocks. It increases the purchasing power of traders manifold. However, the risks associated with this type of trading are also significant. The potential losses with it also magnify. Failing to oblige a margin call from the broker may result in the liquidation of investments.
Continuing with our example above, if the share prices fall to $40 for a long position, the investor would lose $ 4,000 ($60 – $40 = $20 * 200). With a cash account, the investor would have only incurred a loss of $2,000. Stock price fluctuation to this extent does not occur instantaneously in the real world. However, it requires significant initial investments to make profits with small movements in share prices.
Brokers using the invested funds as collateral may lend the money to other traders as well. It may trigger a stock crash if the margin trading reaches beyond a certain level with only borrowed money.
Speculators may lose substantial investments if there are sudden uncertain events that cause stock prices to plunge. Investors may have to wait for stock price recovery before closing the position. It also incurs high margin interest expenses.
Benefits of Margin Trading
Margin trading amplifies the returns on investments. It allows significant trading volumes which wouldn’t be possible with cash accounts only. Large trade volumes provide stability and liquidity to stock markets. Volume trading provides liquidity to listed companies as well.
It has made stock trading fairly easier for retail investors. Access to stock markets for retail investors wouldn’t be possible without margin trading. Short selling is only possible with this trading. It has made it possible for traders to make profits even if the stock prices fall.
Margin trading provides significant opportunities to investors for making profits with low cash investments. If executed correctly, the investors can earn significant profits with margin trading even if the share prices fall (short-selling). However, it amplifies the losses as well. It accelerates the trading risks as well.