In finance, a margin is the amount of funds that the investor or trader must put up from their own resources. It can vary depending on the instrument or asset. Therefore, margin trading is based on borrowing funds from a broker to buy the stock.
What Is Margin Trading?
It is a form of borrowing that lets you leverage the securities you already own. This type of trading may be suitable for any investor looking for extra leverage in their investments. It is not designed for any specific type of customer. MT involves buying and selling of securities in a single session. During the trading session, an investor has to guess the stock movement.
How It Works
You can trade on margin only with a margin account, which differs from a regular cash account in a way that you trade by using the funds in the account.
- To open a margin account, you need to invest at least $ 2,000. This investment is called a minimum margin.
- After you open the account, you can borrow up to 50% of the purchase price of a stock. This deposit is known as an initial margin. The size of the initial margin typically does not exceed 50 %, but it can be lower, for example, 10%. However, some brokers may require you to borrow more than 50%.
You keep the loan as long as you want. But before you start trading, you need to remember the following:
- Maintain the minimum margin throughout the session because the stock price can fall more than one had anticipated.
- Square off your position at the end of each trading session. If you have bought the shares, you must sell them. And if you have sold the shares, you must buy them at the end of the session.
- Convert your position into a delivery order after the trade. Keep the cash ready in order to buy all of the shares that you had bought during the session as well as pay the broker’s fees and extra charges.
MT brings investors the following benefits:
- Ability to leverage the securities. With MT, you can leverage your gains by purchasing more shares than you could if you had only cash.
- Portfolio diversification. MT can help you make your portfolio more diverse by adding positions in stocks other than you typically trade on.
- New trading opportunities. With MT, you can benefit from new trading options right after they appear, without the need to raise cash.
Apart from the benefits, MT has a range of drawbacks and risks, such as:
- High-interest rates. The interest cost on margin debt can grow over time and impact the gains made on margined securities. In addition, the interest rates on margin debt are not flat and can change since the time when the debt has appeared.
- A need to constantly monitor the margin account to make sure that the margin does not drop below the required level.
- Margin calls. If the securities bought on margin have a sudden sharp decline, the investor may have to pay a significant amount of cash or marginable stock during a short time period.
- Forced liquidation. If the investor cannot meet a margin call, the broker can sell the margined securities without notice. This may result in the investor’s position being sold at the worst possible time and at a huge loss.
Margin trading refers to the borrowing of funds that lets the investors leverage their securities. It has a range of benefits, such as instant access to new trading opportunities or portfolio diversification. But MT is also quite risky because of high-interest rates, margin calls, and forced liquidation if a margin call is not met.