Guide to Margin Trading – KOAM

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Margin trading involves borrowing money to buy stocks. This is a risky business strategy that requires you to deposit money in a brokerage account as collateral for a loan and pay interest on the borrowed funds.

What is Margin Trading?

Margin trading, also known as margin buying, allows you to use leverage to increase your buying power and make larger investments than you could with your own resources. But when you buy stocks with borrowed money, you run the risk of racking up bigger losses.

When you open a new brokerage account, you may have the option of choosing a margin account. This type of brokerage account allows you to deposit money and then borrow more money to buy investments.

Margin trading is a type of secured lending. When you take out a loan from your broker to buy on margin, the loan is secured by the investments you buy, similar to how you secure a home equity line of credit (HELOC) with the house itself.

Regulations limit investors to borrow up to 50% of the purchase price of an investment. Brokerages may have other limitations on how much you can borrow for margin trading.

Let’s say you open a margin account and deposit $5,000 in cash, for example. Your broker would allow you to buy $10,000 worth of stock in the account and charge you an annual interest rate on the margin loan.

Interest on margin transactions is usually added monthly to the margin balance. When you sell your shares, the proceeds first pay off the margin loan and what’s left over goes to the account owner.

How does margin trading work?

Margin trading is strictly regulated by the Federal Reserve, the Financial Industry Regulatory Authority (FINRA), and the Securities and Exchange Commission (SEC). Although brokers may have their own rules, here are the common regulations that govern all margin trading:

  • Minimum margin is the minimum amount you must deposit to buy securities on margin. FINRA requires individuals to deposit at least $2,000 or 100% of the purchase price of the securities on margin, whichever is less. Your broker may require a larger minimum margin deposit.
  • Initial margin is the percentage of the original purchase price covered by your own cash when buying securities on margin. The Federal Reserve’s Regulation T allows investors to borrow up to 50% of the initial purchase price of the securities, although some brokers require a higher initial margin.
  • Maintenance margin is the percentage of your equity that you must keep in your margin account when you hold securities on margin. The minimum maintenance requirement is 25%, but it can go up to 40%, depending on the broker. This rule ensures that investors do not go into too much debt and keep their skin in the game.

The biggest risk of trading on margin is a decline in the value of the securities you bought on margin. Since the securities secure your loan, any drop in price reduces your equity and may trigger a margin call.

A margin call occurs when the equity in a margin account is too low to meet the maintenance margin requirement. When this happens, the broker asks the account holder to deposit enough money to cover the maintenance margin, which can lead to a money rush.

To illustrate how these rules work, suppose you open a margin account and deposit $2,000, meeting the minimum margin requirement. Under initial margin rules, you could turn around and buy $4,000 worth of stock in that margin account.

If your $4,000 stock investment lost value to $3,000 for some reason, a broker with a 40% maintenance margin requirement would make a margin call and ask you to deposit an additional $800 in cash on your account.

Advantages of Margin Trading

  • Leverage. The main advantage of margin trading is greater buying power. With a cash account, you can only buy securities if you have enough money to pay the full purchase price. When you buy on margin, you can hold more shares than if you were limited to using your own funds.
  • Magnify profits. Margin trading with leverage can amplify your potential profits and provide more opportunities to buy on margin. This is because when the value of securities increases, not only are the securities you own worth more, but their higher value as collateral gives you more leverage for margin trading.
  • Flexibility. Unlike other types of loans, margin accounts do not have a fixed repayment schedule. You only have to repay the loan when the stock is sold, as long as you meet the broker’s maintenance margin requirements.

Margin Trading Risks

  • Interest. Margin trading is not free and you have to pay interest on the money you borrow from your broker. The interest rate varies by broker and depends on both the amount you borrow and market conditions. Margin interest rates range from 4.75% to 12%. You owe interest regardless of how your investments perform.
  • Margin calls. If the value of securities held in a margin account falls too low and your account equity falls below the minimum maintenance requirement, you will face a margin call. Your broker will ask you to deposit additional money to meet the maintenance requirement.
  • Forced liquidation. If your broker issues a margin call and you don’t deposit enough money by the deadline, the broker has the right to liquidate the securities that were purchased on margin. It can happen without notification, and even if it causes you big losses.
  • Magnify losses. This is the flip side of the amplified profits noted above. If the value of securities purchased on margin declines rapidly, you not only lose your stock investment, but you also owe the broker money for your loan.

Here is an illustration of how margin trading can magnify your losses.

Let’s say you buy $10,000 in stocks in a margin account, half with borrowed money. If the value of the stock drops 20% to $8,000, your account equity drops to $3,000 (remember that all losses come from your equity share). In this case, you have lost 40% of your cash investment.

If you bought $5,000 worth of stock in cash (no margin) and the stock fell the same way, you would only lose $1,000 or 20%. In our example, buying on margin could double your losses.

Is Margin Trading Right For You?

Only experienced investors who are comfortable with risk should consider margin trading. If you are a novice investor, this is not the best strategy as it is a high risk bet that can lead to heavy losses. New investors are probably better off using cash accounts to invest and learn about the market to get started.

If you are considering margin trading anyway, you need to make sure that you have enough cash to cover potential losses if the value of your investments drops. Otherwise, your investments could be liquidated and you could lose a significant amount of money.

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