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Stock investing can be a great way of preserving and growing your wealth. The stock market is home to thousands of companies from different industries that can add value to your investment portfolio. However, stock investing can also be a long and drawn-out process and may require a decent amount of capital to generate sufficient returns. Another way for investors to trade stock is by using a margin. Margin trading involves borrowing money from your stockbroker to buy stocks. This allows traders to increase the buying power of their accounts and gain leverage. However, margin trading is risky and comes with its downsides. Margin trading boosts buying power, but it also amplifies losses. If the account value falls below a certain threshold, the broker may make a margin call and request you to liquidate your positions or add more capital to the account to continue trading.
Nonetheless, margin trading is a commonly used strategy to boost profits by increasing leverage. If you are interested in how margin trading works in practice, as well as the risks associated with the strategy - this investfox guide is for you.
Margin trading refers to the process of borrowing money from a stockbroker to increase your buying power and make larger trades than what your capital allows for. The rationale behind margin trading is to make the same trades as you would with your own funds, but with an increased sum. This allows traders to make the most out of their strategies in terms of dollar value.
For example, a 5% return on a trade done with $10,000 is $500. If we assume a leverage of 3:1, the trader would be able to make the same trade with $30,000, which would net them $1,500.
Margin trading is especially popular among Forex traders, but stock traders also tend to use leverage when dealing with positions of high probability. Choosing whether to use a margin or not depends on the confidence level of the trader, as well as the trade they are planning on executing.
Margin trading consists of three key aspects that are essential for the process:
The stock market can be a volatile place. The prices of stocks are constantly changing, which creates an inherent risk for any trading activity. Adding leverage to an already risky trading experience is guaranteed to heighten the overall risk. Trading on margin requires interest rate payments, while the borrowed funds are also at risk. If a margin trade fails and underperforms, the trader may receive a margin call, which restricts additional trades unless the losing trade has been liquidated, or additional funds have been added to the account to pay back the margin. Such trades can be stressful and could lead to panic trading to pay the broker in time. Increased buying power may also prompt traders to take more risks, which might backfire and eventually lead to a margin call.
“In addition to magnifying losses as well as gains, leverage carries an extra risk on the downside that isn’t offset by accompanying upside: the risk of ruin.” - Howard Marks
To better understand how margin trading works in practice, let’s look at two scenarios of the same trade. Suppose a trader bought $10,000 worth of stock, out of which $5,000 was financed using leverage. We can compare the results when the stock price rises or falls.
Suppose the value of the $10,000 initial stock investment rises by $2,000 and reaches $12,000.
If the trader sells the position for $12,000 and pays off the $5,000 loan (plus interest), they would be left with the account cash balance minus the loan principal and interest payments.
In this case, the trader would be left with $7,000, minus the interest payments made during the borrowing period.
If the stock price falls by $2,000 and the value of the investment reaches $8,000 and the trader liquidates the position, they would be left with $3,000, which is less than the initial cash investment made by the trader, which was $5,000. Thus, the trader has actually lost $2,000 because of the trade, plus the interest payments made during the borrowing period. This highlights the loss-amplifying risk of trading stocks on margin.
Margin calls and margin maintenance requirements are some of the most important concepts behind margin trading. They represent the tools used by stockbrokers to protect their funds from reckless margin lending by placing constraints on how much traders can borrow and what thresholds they need to meet to qualify for margin trading.
Margin maintenance requirements serve as levers for brokers to halt the client’s ability to make further trades until they have sufficient equity in their account. For example, if the minimum margin maintenance required by a broker is 40% and the total equity value of a client’s account drops below that level, the broker will make a margin call and will require the client to add a sufficient amount of liquidity to their account to meet the 40% threshold again. Unless the client does so, the broker retains the right to liquidate the client’s holdings to cover the margin. The broker may also place additional constraints on the account until further notice.
Margin calls are exercised by brokers once the total equity value of a client’s account has dropped below the minimum margin maintenance level. This is done to protect the client’s funds from dropping further in value and making them unable to pay back the borrowed margin.
Margin calls give the broker full authority to act in their best interest, if the client does not comply to increase the equity value of their account, or cannot do so in time. In this case, the client could face restrictions by the broker, or, in some cases, their account might be closed.
“Almost every financial blow-up is because of leverage.” - Seth Klarman
There are numerous risks associated with trading stocks on margin. Some of these risks include:
Yes. Most stockbrokers offer margin trading to their clients. However, the maximum leverage amount is usually limited and less than that of Forex brokers.
Yes. Margin trading involves risks that may not be as evident when trading with cash. Margin is a loan taken from the broker and represents a liability to the trader. Margin loans are charged interest, which is an additional important consideration for margin traders.
A margin call happens when the equity value of a trader’s account falls below the maintenance level set by the broker. Once the margin call has been made, the trader must increase the value of their account, or the broker has the authority to liquidate the necessary amount of their assets to cover the loan and interest.