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
- Lower Cost
- Higher Returns
- More Flexibility
- Increased Risk
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.
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.
Looking for more investing strategies? Consider joining one of Infinity Investing’s stock trading workshops for helpful trading tips presented by our stock market experts.
Pros of Trading on Margin
Now that we’ve explained what margin trading is, let’s explore some of the upsides associated with using this trading tactic:
1. Lower Cost
This is not entirely accurate, because at the end of the day you are responsible for the money you borrow on margin, and using margin to buy stocks does not make them any cheaper. However, the trades you make do come at a lower cost in the sense that you don’t have to use your own cash. Rather, you use funds provided by the broker, and keep the cash in your bank account.
2. Higher Returns
Margin trading also allows you to amplify your returns. For example, if you only have $500 to purchase a certain security on an upward trend, and by the end of the week that $500 would double, your capital gains using your own money are limited to $500.
However, if you have a margin account and borrow $500 (essentially 50 percent margin) to make the trade, you are looking at gains of $1,000.
3. More Flexibility
Many investors who actively trade on the stock market are not buying and selling stocks, but rather buying and selling derivatives, like options. Options are contracts that give an investor the right (but not the obligation) to buy or sell securities at a fixed price, if the option is exercised.
Let’s say an investor buys a call option for a certain stock at $40, and the stock price soars to $80. If they exercise their option, they can buy 100 shares of said stock at $40 per share. But what if they don’t have $4k to do so? Trading on margin will allow this trader to exercise the option. Then they can hold on to the stock or sell it at the market price, easily pocketing the $80 per share that same day—enough to pay back the borrowed money and then some.
Cons of Trading on Margin
While trading on margin has a few pros, it also has a few downsides. These drawbacks include:
Margin trading is a fancy way of saying borrowing money to buy stocks. This means margin traders are putting themselves into debt, and with debt comes interest—which can snowball the balance owed.
That’s why many margin traders only trade on margin to make short term trades—like exercising a call option (as mentioned above) to snag a certain stock at a great price or to buy a certain security and sell it after a certain point.
Margin interest rates aren’t as high as the double-digit credit card rates, but they are higher than the typical rates for a car loan or home mortgage. For example, at the time of this article, Fidelity margin accounts charged 8.325 percent on balances less than $50k; 6.825 percent on balances more than six figures; and four percent on balances more than seven figures.
As you can see, these interest rates make margin trading very unattractive for anything other than short term trading. This is because the stock market may not grow faster than the interest rate being charged on the borrowed money—meaning you are either breaking even or possibly losing money.
3. Increased Risk
There is a big distinction between trading vs investing. Trading capitalizes on market swings, and can be quite disastrous if things don’t go according to plan. And while capital gains can be amplified with margin trading, so can capital losses.
The risk associated with margin trading is not one that the average retail investor should take on. Margin trading is best for day trading investors who understand how to capitalize on market movements or who use derivatives to make a profit.
Does a Margin Account Affect Your Credit Score?
Margin accounts are not reported to credit reporting agencies, so no, they do not affect your credit. However, as previously mentioned, there are a few cons to margin trading for the everyday retail investor.
The individual components of a person’s overall financial health are often related, so if a margin account is wiped out and the investor loses their collateral, they are losing a potential source of funds and may need to turn to a personal loan or credit card. If you like the sound of margin trading or cutting-edge stock market strategies, there are less risky trends to explore, such as ethical investing, fractional share investing, or robo apps.
It’s also important to note that borrowed funds from a credit card or personal loan do impact your credit score. Sometimes banks offer special promotions on a credit card, such as zero percent interest for 12, 18, or 24 months. Many savvy consumer investors will take advantage of what known as a direct deposit to have the credit line dumped into their bank account. With the interest at zero percent for a year and a half, they can invest it in a cash or brokerage account and begin trading. Just keep in mind that this money isn’t part of a margin account (even if it’s similar to trading on margin) and it will be reported to the credit agencies.
Trading on Margin is a Risky Strategy for Long Term Investments, But Could Pay Off for Day Traders Looking for Short Term Gain
Margin trading is a great tool for reducing the amount of cash you personally put on the line while offering flexible stock market strategies and amplifying your gains. Unfortunately, it also puts you in debt and is subject to interest, which increases the risk.
Margin investing is typically reserved for stock market traders who know what they are doing. If you are not familiar with how to gauge market activity or how the derivatives market works, margin trading is (in all honesty) probably not for you.
That doesn’t mean you can’t get involved in the stock market. In fact, there are plenty of other ways to make a profit on Wall Street. Join Infinity Investing to learn how some of these strategies work, and to see which one is right for you and your financial goals.
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