While there is some risk to it, the benefits of margin trading can outweigh the hazards. It’s a familiar tool for many investors. Because when used properly, it can offer a substantial boost to an active trader’s portfolio.

Balancing the risks and benefits of margin trading

Margin trading gives access to additional investable capital. It’s essentially a line of credit – or loan – from a brokerage. It operates similarly to a home equity loan. Except that instead of using the equity of a home as collateral, you can use cash or securities as collateral.

The amount of a home loan is determined by the value of the property. And how much margin a brokerage is willing to offer is based on the value of the investment holdings and cash in the account.

So why would anyone invest with borrowed money? For the same reason someone would take out a home equity loan for a home improvement project.

Let’s say someone takes out a home equity loan of $15,000 to update the kitchen. Those new quartz countertops, fancy stainless steel appliances and custom cabinets could add a lot more to value to the home when it’s time to sell. In this case, a home loan makes perfect sense.

If the home equity loan were used to buy a new car that instantly depreciates, that’s a bad use of it. Same goes for using it to fund a vacation or pay for college. You’ll most likely never see a return on investment in those cases.

So like with a home equity loan, the benefits of margin trading depend on what you do with it. If an investor uses a margin loan to invest willy-nilly in volatile stocks, they’re gonna have a bad time. Margin is best used on proven investment strategies.

How to Reap the Benefits of Margin Trading

First off, trading on margin can be treacherous. It can wind up costing an inexperienced investor even more than they have in their account. If margin is used to buy stocks or securities that plummet in price, the brokerage can issue a margin call. This results in a “fire sale” of any holdings in the account. And if the brokerage isn’t able to recoup the costs of margin lent from this liquidation of assets, the borrower is still on the hook for outstanding debts.

This is why in the wrong hands, margin can be disastrous. But – and this is a big but – when margin is properly harnessed, it can lead to increased gains and a turbocharged portfolio. You just have to be aware of the possible pitfalls. Here are four valuable keys to benefiting from margin trading.

  • Keep It Quick
    Just like any other loan, margin accrues interest over time. On the road to financial freedom, it’s imperative to pay off most debts as fast as possible. So keep those trades on margin reserved for strategies with brief timelines. Margin isn’t appropriate for a “set it and forget it” investment. It’s best off in the hands of cyclical, swing or day traders.
  • Choose Your Target Wisely
    While it’s important for any investment, doing your homework beforehand is even more critical when investing with someone else’s money. So stick to investing in companies with strong fundamentals… or with a proven and predictable pattern of price fluctuations.
  • Have an Exit Strategy
    This goes for any investment strategy, but it’s especially important when trading on margin. Set a target price that you plan on exiting at before you start. This will help prevent you from getting greedy if the price goes up. The same goes for preventing excess damage. Set a stop loss to prevent a losing investment from losing too much. Taking emotions out of the decision will only help in the long run.
  • Always Avoid Margin Calls
    This is the worst-case scenario. But if the assets that are being traded on margin fall in value by 70% or more, a brokerage can and most likely will sell any assets in the portfolio. This can result in outsize losses.

Why Trade Using Someone Else’s Money?

Now that you know how to benefit from margin trading, it’s time to go over the why. Just as a home equity loan can quickly pay for itself if used properly, margin trading can be worth the risks if executed with caution.

In order to have access to a margin loan, you need to fulfill a few obligations. The process starts with filling out a margin agreement with a brokerage. This form will outline all of the details you need to know. This is where you find out what kind of interest rates will be applied and the minimum account balance needed.

Once you’ve agreed to the terms, you make a deposit into the account – usually at least $2,000. Once the account has funds in it, the margin account typically allows an investor to double the amount they invest with. So if you’ve deposited $2,000, you should be allowed to invest $4,000. If you deposited $20,000, you should have $40,000 to invest.

Here’s Where It Gets Interesting…

If a company’s fundamentals look strong and it’s currently undervalued, its stock price could be poised for a big breakout. And margin can be a valuable tool to have on your tool belt.

Let’s use the biotech firm AbbVie (NYSE: ABBV) as an example. The company didn’t get too involved in the search for a vaccine against the coronavirus. For AbbVie, it was business as usual. And the stock price suffered slightly for it.

Some of Abbvie’s investments have yet to pay off. Its acquisition of Botox-maker Allergan in 2020 didn’t pan out so well while folks were in lockdown. But when things return to normal, AbbVie could be in the driver’s seat for this cosmetic and medically used treatment.

And here’s where the benefits of margin trading come into play. An investor with $5,000 deposited in their margin account can have up to $10,000 to invest with. If AbbVie is still trading below $100 on the cusp of folks returning to these treatments, it could make sense to pick up 100 shares of the company. And if the return to normal results in an uptick in Botox treatments, that could rapidly increase the share price.

Let’s say AbbVie shares jumped up to $150. Suddenly that initial $5,000 investment is worth $15,000. All that’s left to do is pay back the $5,000 margin loan and the little bit of interest. The margin helped to nearly double the investment.

On the other hand, if the investor had invested only their own money, they would have seen only a 50% return.

Ready to Take Advantage of Margin Trading?

Margin trading can be a risky endeavor. But when used properly, it can pay for itself. If you’re ready to put it to work but are still looking for a little more guidance, be sure to sign up for the free Trade of the Day e-letter.

The investment experts at Trade of the Day can give you all the guidance you need to start spotting stocks on the upswing. They’ll even show you how to take advantage of market downturns. No matter what the markets are doing, there are plenty of investment opportunities out there. So sign up today.

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