Margin trading is when you qualify to borrow money against your existing stocks to purchase more shares. In theory, this can increase your returns, but there are risks associated with it.
Definition and Examples of Margin Trading
When many traders want to buy a stock, they either deposit the necessary cash into their brokerage account to fund the purchase or provide it by gathering profits, interest, and rent from their current investments. However, this is not the only way to buy stocks, and the alternative is known as “margin trading.”
In the most basic definition, margin trading occurs when an investor borrows money to buy stocks. Typically, your broker lends you the money at relatively low rates. In fact, this gives you greater buying power for stocks or other eligible securities than the cash you have alone. Your account, including any assets you hold, acts as collateral for this loan.
However, it is not the broker who shares in this investment with you and will not share in any of the risks. The broker simply lends you the money. Regardless of the stock’s performance, you will be responsible for repaying the loan.
The terms and conditions of margin accounts vary, but generally, you should not expect to have the ability to set repayment plans or negotiate terms of your debt. Your broker can legally change the terms at any time, such as the amount you need to maintain in terms of equity. When you are asked to add cash or securities to your account, this is known as a “margin call.” If you cannot quickly deposit cash or stocks to cover the margin call, the broker can sell securities in your account at their discretion.
Unlike a margin account, a cash account requires investors to fully fund the transaction before executing it. You will not incur debt when using cash accounts, and you cannot lose more than the money you deposit in the account.
How Does Margin Trading Work?
Margin trading requires a margin account. This is a separate account from a “cash account,” which is the standard account that most investors open when they start trading.
All the securities in your margin account (such as stocks and bonds) are considered collateral for the margin loan. If you fail to meet a margin call by depositing additional assets, your broker may sell some or all of your investments until the required equity ratio is restored.
Maintenance requirements vary from broker to broker. This is the ratio between the equity of your holdings and the amount you owe. In other words, it is how much you can borrow against every dollar you deposit. The brokerage has the right to change this at any time. The interest rate charged by your broker on margin loans is also subject to change.
Note: It is possible to lose more money than you invest when trading on margin. You will be legally responsible for repaying any debts incurred.
Margin Trading Scenarios
Imagine that an investor deposits $10,000 into an empty margin account. The firm imposes a maintenance requirement of 50% and charges an interest rate of 7% on loans under $50,000.
The investor decides to buy a stock in a company. In a cash account, they would be limited to the $10,000 they have deposited. However, by using margin debt, they borrow the maximum allowed amount, $10,000, giving them a total of $20,000 to invest. They use almost all of this money to buy 1,332 shares of the company at $15 per share.
After
Purchasing the stock, the price drops to $10 per share. The portfolio now has a market value of $13,320 ($10 per share × 1,332 shares). Despite the drop in stock value, the investor is expected to repay the $10,000 they borrowed through a margin loan.
The problem in this scenario is that in addition to the outstanding debt, the value of the stocks that return to the investor is only $3,320. This makes the investor’s equity represent about 33% of the margin loan. The broker issues a margin call, forcing the investor to deposit cash or securities worth at least $6,680 to restore their equity to the 50% maintenance requirement. They have 24 hours to meet this call. If they fail to meet the maintenance requirements within this timeframe, the broker will sell the securities in their account at will.
If the trader had not bought on margin and only purchased stocks they could buy with cash, their loss would have been limited to $3,330. Furthermore, they wouldn’t have had to realize that loss. If they believed the stock price would rise again, they could hold their position and wait for the stock price to rise again.
However, since the trader in this scenario used margin trading to purchase the stock, they must either pay an additional $6,680 to meet the maintenance requirements and hope for a rebound in the stock price, or sell the stock at a loss of $6,680 (plus interest expenses on the outstanding balance).
Advantages and Disadvantages of Margin Trading
Advantages
- You can purchase more than your cash account allows: Your cash account limits the maximum cash you have on hand. If there is an investment you are interested in, you can invest larger amounts using margin trading.
- Higher returns can be achieved through investing borrowed funds: The more shares you buy, the greater your chances of achieving higher returns. Margin trading enhances your returns.
Disadvantages
- You can lose money: If you borrow to invest more and this investment loses value, you will lose much more than if you had only used the cash you had on hand.
- Rehypothecation risk: Rehypothecation occurs when the debtor’s collateral is used from the debt agreement. In a margin account, all your securities are considered collateral, and your broker may choose to use them as collateral for their own trades and investments. When collateral is used for multiple transactions, a “collateral chain” is created, linking more parties to the same collateral. Collateral chains increase the fragility of financial markets. If one of those transactions goes bad, it may cause repercussions that affect more people rather than just the two parties involved in a single transaction.
Note: Failing to cover significant losses in margin trading may ultimately lead to bankruptcy.
How to Get Margin in Your Account
Obtaining a margin account is relatively easy if you meet the minimum cash requirements. This requirement is known as the “minimum margin.” The Financial Industry Regulatory Authority (FINRA) has set a minimum margin of $2,000.
Once you’ve met the minimum margin, all you need to do is fill out the application form to apply for a margin account. You can open a new margin account or add margin trading capabilities to your existing brokerage account. In either case, the application process is likely to be similar.
Frequently Asked Questions (FAQs)
What is the margin rate?
The margin rate is the interest rate charged by your broker on your margin loan. The interest rate may vary depending on the size of your margin loan.
How much
How many people use margin for trading?
Many people use margin for trading. According to FINRA, as of May 2021, investors borrowed $861 billion for margin trading. Investors hold $213 billion in their cash accounts and $234 billion in their margin accounts.
What happens when you don’t have the money to pay off your debts when trading on
Source: https://www.thebalancemoney.com/margin-101-the-dangers-of-buying-stocks-on-margin-356328
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