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Margin Trading

What is Margin Trading?

Margin trading is the act of trading securities (stocks, bonds, etc.) on margin or credit. It leverages borrowed funds from a brokerage firm in order to purchase an asset. The term margin refers to the difference between the value of securities in the investor’s account and the borrowed funds. Margin trading allows for greater purchasing power for investors with the potential for higher profits when prices rise but equally greater losses if prices dip.

How does Margin Trading work?

Those who wish to trade on margin must open a margin account at a brokerage. These accounts differ from cash accounts in that they offer borrowing options. Typical initial investments are a minimum of $2,000 to open a margin account, however some brokerages require a higher amount.

The investor can borrow up to 50% of the purchase price of a stock with margin trading. For example, if a stock is priced at $100 and the investor wants to spend $50 in cash, they can borrow $50 (50%) to fulfill the purchase.

Investors can also choose to borrow lesser amounts, for example, they can choose to spend $75 of their own cash and borrow $25 (25%) instead for a $100 stock.

The loan can typically be kept for as long as the investor wants. However, when securities are sold in the account, the sale funds are first applied to any outstanding loans until they are fully repaid.

The longer that the borrowed funds sit in the account, the greater the accrued interest. Because interest accrues on borrowed funds, margin trading is frequently used for short term investment strategies.

What is a Margin Call?

The maintenance margin is the minimum percentage of equity that must be maintained in the margin account. Equity is defined as the total value of securities in the account minus any borrowed funds.

The minimum is set by the Financial Industry Regulatory Authority at 25% of the total value of the securities in the account, but many brokerages require a higher percentage of 30 to 40%.

When the equity percentage drops below the minimum set by the brokerage, a margin call is issued.

A margin call is simply the brokerage requesting the sale of stocks or the deposit of cash in order to raise the equity percentage back up to meet the minimum (whether it is 25%, 30%, 40%, etc.)

If a margin call is not met within a specified period of time, it may trigger the automatic sale of securities in the account to meet the margin call.

Positives and negatives of Margin Trading

Margin trading offers greater flexibility to investors by allowing them to purchase more of a security than they would normally be able to with solely cash.

On one hand, they have the opportunity to earn higher profits when stock values rise due to the larger amounts they are purchasing. However, potentially losses are equally magnified with margin trading.

Another downside is the interest on the borrowed funds. Interest rates will vary from one brokerage to another and they can be a significant cost when borrowed funds are not repaid in a timely manner.

Also, not every stock can be purchased on margin. Those that are marginable are determined by the Federal Reserve Board. Typical stocks that are excluded from margin trading include penny stocks, IPO stocks or over-the-counter bulletin board (OTCBB) securities because of their volatile nature, but others may also be excluded.

Tips for using Margin Trading

Successful margin trading is challenging and not recommended for newer investors. Because the risks are higher, it is recommended that beginning investors work with a financial expert and follow some best practices:

  • Be selective - buy securities that you are more familiar with. Wrong guesses cost significantly more with margin trading so stick with what you know.
  • Avoid margin calls - margin calls can result in the forced sale of stocks at the wrong moment, forcing a loss or missing out on a rally. Therefore it is recommended to keep the account above the maintenance margin.
  • Start small - start on a smaller level and scale it up as you get more familiar with it. Try it with one or two familiar securities to experience the risks and rewards of margin trading along with discipline and then work your way into bigger investments.

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