What is Trading on Margin?
Trading on margin, also known as margin trading, involves buying stocks with borrowed funds. It’s a tactic mostly used by day traders looking to increase their gains in the stock market.
Pros and Cons of Trading on Margin
PROS:
CONS:
The average retail investor who buys and sells stocks does so using money they have deposited into a brokerage account, whether that’s through a traditional financial institution, like their bank, or an app, like Robinhood. The idea of borrowing money to capitalize on market movements is not as relevant because such retail investors are often not following market news like a professional stock trader.
In fact, most?retail investors ?do not buy and sell stocks at all, but rather have a portion of their paycheck go into a managed retirement account.
What is Margin Trading?
Some investors do buy and sell stocks, and some of them do not always have the funds to take advantage of an amazing investment opportunity. Think of it in terms of a different asset class, and it will seem more understandable.
For instance, if a real estate investor saw a foreclosed home on the market that they knew they could fix and flip, but they didn’t have the cash, they would find a silent investor to contribute funds. The same is true in the stock market. A stock market investor who believes that a certain security is set to take off, but doesn’t have the funds to make the purchase, can borrow money from their broker. This is margin trading.
Margin investing is also called leverage trading, because a day trader placing a margin trade uses their margin debt to achieve a bigger trade than they could with their own account equity.
As we will see, though, there are margin rules to follow, such as the maintenance margin requirement and the margin rate of interest. In fact, margin trading probably carries a lot more stipulations than using borrowed funds from a private investor or someone in your network to place a leveraged trade. However, these rules allow traditional financial institutions to provide margin funds to a wider range of investors because the lender protects itself through the margin trading agreement and what it entails—namely that the margin portfolio itself is collateral.
How Does Trading on Margin Work?
First off, you need to be approved for a margin account, instead of a regular brokerage account. The cash and securities in your account will serve as collateral in case your investment does not work out.
The amount of initial margin you have corresponds to the amount of liquidity you own already, in comparison to the amount you are borrowing. For instance, if you have $5k in your account, and want to borrow $5k more to buy a certain stock, your initial margin is 50 percent. Understanding initial margin is important because investors trading on margin can only borrow up to 50 percent of a security’s cost.
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The borrowed money can be used to buy securities or derivatives, but you will need to pay interest on that money—just like any other loan. Of course, the hope is that your buying and selling activities will result in making enough money to repay the loan, cover the interest, and then some.
How to Start Margin Trading
To get started with margin trading, you need a minimum deposit of at least $2k.
Generally, brokerages issue what’s known as a periodic margin call. This means a margin trader must deposit more money into the account in order to make sure they are adhering to maintenance margin or the minimum account balance.
Some brokerages also charge fees and commissions for margin trading. Between the fees and commissions and margin interest rate, it becomes clear that margin trading is really only best suited for investors who will be entering and exiting positions relatively quickly—also known day trading.
Margin trading is not attractive for long term growth because the interest rates will often not outpace market growth. In some cases, an investor will be borrowing such a sizable amount of margin funds that the interest rate will be lower, but it is still high enough to make margin trading for a long position something that doesn’t make much sense. Margin trading is really for investors who are capitalizing on short-term market movements, whether it’s stock trading or forex trading.
Margin Trading vs Short Selling
Margin trading is not the same thing as short selling. With margin trading, you borrow funds. In short selling, you actually borrow securities, sell them, pocket the money, wait for the price to fall, and then repurchase them to return the security to the original lender.
While there is a difference between margin trading and short selling, you will likely need a margin account in order to short sell stocks because the broker is granted the right to hold your margin account as collateral.
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