What is Margin Trading?
Margin trading is trading using money borrowed from your broker. Effectively, it can be thought of as taking out a loan from your broker.
Although buying and selling on margin does not provide leverage in and of itself, it can be used as a form of leverage. This is because the amount of margin you are allowed to take out typically depends on how much money you have in your account. Some brokers allow a 4:1 ratio of margin to your cash balance, while others allow a 6:1 ratio. Beware, however, that many brokers offer a significantly higher ratio of margin to cash balance for intraday margin trades than for positions held overnight on margin. As an example, if your cash account has $50,000 you may be able to use up to $200,000 in margin for intraday trading (a 4:1 ratio) but loan only $100,000 overnight (a 2:1 ratio).
Requirements for a Margin Trading Account
Trading on margin requires opening a margin account separate from your cash account with your broker. FINRA requires margin accounts to have a minimum of $2,000 cash on hand in your account, however, the exact minimum balance varies by brokerage and can be much more than $2,000.
In addition, loaning money from your broker is not free. The margin must be returned with interest, and different brokers charge varying interest rates that also change with prevailing interest rates. Margin interest rates are typically lower than personal loan rates, making it more favorable to borrow money through your broker.
Who is Margin Trading Best For?
Margin trading comes with additional risks since you are putting loaned money on the line with your trades. In addition, managing your margin account to maintain a sufficient cash balance relative to margin amounts can be tricky to master as market prices are constantly changing, minimum balances differ between intraday and overnight trades, and you must pay interest on the loans from your broker. For these reasons, margin trading should only be used by experienced traders who are comfortable with managing risk and fully understand how margin accounts work. If you do plan to use margin, strongly consider diversifying your portfolio to protect yourself against sudden changes in the market that can lead you to fall below your required margin account balance.
Benefits of Margin Trading
Increase Buying Power and Profit Potential
Margin trading offers you the ability to increase your buying power and, correspondingly, your potential profits from trading. Margin trading allows you to buy a greater value of stocks and options than you necessarily have cash on hand to purchase. The exact boost in purchasing power depends on your broker’s required ratio of cash to margin in your account, but often you can purchase up to four or six times your cash balance in margin. Accordingly, this increases your potential profits since every upward tick in a stock’s value is multiplied by four to six times what it would be without margin purchases.
Take Advantage of More Trade Opportunities
One of the best features of margin trading is that it allows you to take advantage of more trading opportunities than you could using only your cash on hand. Importantly, margin can – and often should – be used to purchase multiple stocks rather than double-down on a single stock. For example, if you take out $10,000 in margin, you could buy $2,500 worth of each of four stocks rather than putting all the money into one trade. This allows you to diversify your portfolio, and particularly your portfolio of stocks bought on margin, to better manage your risk while increasing your trading opportunities.
Another use of a margin account is the ability to short stocks, which in turn allows you to profit when a stock’s price declines rather than increases. Margin is required for short selling because you are in essence borrowing stocks in the same way that you would borrow money on margin.
Don’t Wait for Funds to Settle
Normally, your brokerage account will not allow you to make another trade after selling a stock until the funds have settled – which can take hours to days, depending on your brokerage. Margin accounts, on the other hand, don’t require funds to settle before you can trade on them. This can be especially important for intraday trading when liquidity can become an issue if trades take a significant amount of time to settle.
Downsides and Risks of Margin Trading
One of the immediate downsides to margin trading is that it adds in another expense from your broker – interest on your loan. Although margin interest rates are typically lower than personal loan interest rates, the charges can quickly add up if you are frequently trading on margin.
The dreaded margin call, by which your broker lets you know that your account’s balance is below the required amount to maintain the amount of margin you have taken out, is a significant downside to trading on margin. When you receive a margin call, you have a limited window of time to either deposit additional funds, transfer existing stocks from your cash account into your margin account, or sell some of your stocks purchased on margin. Altogether, this means that if you do not have extra cash lying around to rectify your account balance you could be forced to sell at a loss rather than wait out a low price period in a stock.
Trading on margin can also introduce significant risks into your trading. Doubling your buying power also means that you have double the potential loss when a trade goes wrong – hence the importance of using your margin to diversify your portfolio. Even when diversified, if your strategy is not profitable, using margin can actually magnify your losses in the long run and add interest charges to your trading expenses. Many inexperienced traders are simply not prepared – psychologically or financially – to handle the large and diverse portfolios that come with the added buying power from trading on margin. It is important to consider whether these risks are worth the potential gains before trading on margin.
Trading on margin is an excellent way for experienced traders to boost their purchasing power and explore trade opportunities that they otherwise couldn’t using on-hand cash alone. However, margin trading comes with significant risks, especially if used incorrectly or to double-down on individual trades, and can make managing your trading accounts more complex. Be careful to fully understand how margin works and spread your risk across a diverse portfolio before jumping headfirst into trading on margin.