You may have wondered, “What is margin trading?” But you quickly became intimidated by the many moving parts involved. You know that professional investors use it. It sounds sophisticated. But the bottom line with margin trading is that you will go into debt in order to invest.
Inventors uncomfortable with assuming debt might be immediately turned off. But with great risk can come great reward. Otherwise, no investor would take the risk, right?
Here’s the thing: The key to any investing strategy is understanding what you’re getting yourself into.
In this article, we’ll break down what margin trading is, how margin trading works, and how to tell if margin trading is for you.
What Is Margin Trading?
Normally with stock trading, you use cash. For example, you might transfer cash from your savings to your brokerage account to purchase stock.
With margin trading, however, you’ll be buying stocks or other types of investments with debt. So you’ll be borrowing money in order to invest.
Borrowing Funds to Invest With
Going into debt, taking out a loan, owing someone cash, borrowing funds, borrowing money … think of it in whatever way you need to. But make sure you think of it. We don’t say this to scare you, but it’s an important element to understand right off the bat.
When buying on margin, usually it will be a brokerage firm that gives you the loan. Because you’re using someone else’s money to buy stocks, you naturally give up some ownership and some control.
Borrowing money is a big deal. So of course, there are going to be some rules. These rules are called margin rules and are established by Regulation T of the Federal Reserve Board. According to these rules, investors can borrow up to 50% of the investment’s purchase price.
And also, as with any loan, there will be interest charges as well.
Why Do Investors Buy on Margin?
Wondering why anyone would use margin? Seasoned investors buy on margin so they can do more with their money. This is called leverage.
First, they can buy more stocks because the margin loan provides them with more money. Second, the investor can now use other funds they have set aside to invest in other areas.
The Pros and Cons of Margin Trading
Let’s be clear. Margin trading will not be for every investor.
Some investors are dead set against taking on any form of debt. And that’s OK. But knowledge is power and understanding the balance of risk and reward is important when facing any investment decision.
The Pros of Margin Trading
We touched on this above when explaining why investors buy on margin, but let’s take a deeper dive into the advantages of margin trading.
First, margin trading increases buying power.
By borrowing money, you can buy more than you otherwise would be able to. This means you can buy more shares of stock. This also means that you might invest in stocks with very high share prices.
Take Tesla (NASDAQ:TSLA) as an example.
Let’s say it’s June 2020, and you’d like to invest in Tesla, but the $200 share price is a little out of your reach. So you decide to use margin trading to get the cash you need. You’re now able to buy 100 shares of the stock. Fast forward to summer 2021 when Tesla was trading in the $600s. Margin trading has helped you make $40,000 ($400 increase per share on your 100 shares = $40,000).
In the above example, you can see the potential of margin trading.
Let’s use another example. Margin trading enables you to take larger positions in stocks that you believe in.
Let’s say that without a margin loan your friend Joe could only purchase 50 shares of Tesla stock in June 2020. A year later, Joe would only have made $20,000 ($400 increase per share on his 50 shares = $20,000).
But if margin trading had enabled Joe to purchase 100 shares of Tesla stock, Joe’s capital gains would have been $40,000 ($400 increase per share on his 100 shares = $40,000).
Buying on margin can enable you to diversify your portfolio.
If you’re using only the cash that you have on hand, you may only be able to purchase a few stocks and bonds. But by taking a margin loan, now you can purchase other stocks, bonds, mutual funds, REITs, ETFs, etc.
When you diversify, you’re spreading your money around and trying to increase your chances of investing in a winner.
Let’s look at an example:
Imagine you have $50,000 in cash available in your brokerage account. If you wanted to buy stock in XYZ company with a purchase price of $50,000, you could use $25,000 of the cash you have available and borrow $25,000 from the brokerage firm, according to the Federal Reserve Board’s margin rules.
You could then use the remaining $25,000 to invest in another area to diversify your portfolio and manage market exposure.
Cons of Margin Trading
After our earlier Tesla example, margin trading might sound like a slam-dunk. But of course that’s not true. Hindsight is always 20-20. Here are some of the cons of using a margin trading strategy.
Leveraging your money can let you invest in larger positions. If the investment does well, you’ll enjoy greater returns. But leverage is a double-edged sword. If the investment performs poorly, your losses can pile up quickly.
Brokerage firms have to manage the risk from the loan they made to you. So they will establish a margin agreement and include something called a maintenance margin. Each firm determines the amount you’re required to keep in your margin account at all times.
Your margin account is one type of brokerage account. The other is your cash account. Trades made with your cash account are made with available cash. When you’re trading on margin, you’ll be using your margin account, which allows you to borrow money against the value of the securities in your account.
If the stock price takes a nosedive and your account falls below the margin requirements, the broker will issue a margin call.
This is where we get into worst-case scenario territory. When you fall below the maintenance requirement, the broker sells your shares to get their money back. They can do this without your consent, which means you have no shares, and you still owe them money for the part of the loan that’s left unpaid after they sold your shares.
Margin Loan Interest Charges
Of course, the lender is going to want something in return for shelling out that money. The first thing they’ll want is an interest payment.
Let’s assume you’ve purchased stock in XYZ company for $50,000 and borrowed $25,000 from the brokerage firm. If that $50,000 initial investment in XYZ stock grows by 5%, your profit will be $2,500. From that profit, you’ll have to pay interest on the amount you borrowed.
Margin interest rates vary depending on the size of your account balance and can be as high as 10%.
Alternatives to Margin Trading
After weighing the pros and cons of margin trading, many investors will realize that market volatility pushes the risk profile of margin trading too high for them.
There are different investment strategies, however, that can provide some of the benefits that we’ve outlined above, like increased buying power and diversification.
For one, you can sell other investments in your portfolio to fund new investment opportunities.
Or you can fund portfolio additions with other debt sources that don’t have a looming possibility of a margin call, like a home equity line of credit.
Some investors choose to try options trading, which involves a smaller initial investment. With options trading, you buy the option to buy or sell the stock, not the actual stock. The cost of an option is a fraction of the actual stock price.
Getting Started With New Investment Strategies
Whether you choose to explore margin trading or another one of the strategies we’ve mentioned here, it’s always a good idea to keep learning. You’re doing that by reading this article, so congratulations!
You’ve learned what margin trading is, the pros and cons, and even a few alternatives that are similar in strategy.
By learning about margin trading, you’re also learning more about different investment ideas like leverage and diversification. We hope you’re realizing that there’s more than one way to achieve those things.
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