The Power and Pitfalls of Margin Trading
Margin trading can add a potent boost to an investor’s purchasing power. But it can also lead to financial ruin if not used properly. Now, some financial institutions can be stingy with how much and to whom margin is offered. But it remains a useful tool for an experienced investor or trader… once they know how to harness it.
Let’s start with the basics. Margin trading – also known as trading on margin – is essentially a line of credit offered by a brokerage. This loan (usually with interest) allows an investor to buy more stocks or securities than they would otherwise be able to afford.
To open the door to margin trading, an investor first needs to set up a margin account with their brokerage. This is different from a typical cash account used to invest in stocks and options. This process is fairly straightforward. All you have to do is sign a margin agreement.
Once the margin account is established, a cash deposit of at least $2,000 is usually required. This rule was established by the board of governors of the Federal Reserve to protect rookie investors from getting in over their heads. That $2,000 is just the minimum. It’s possible to set up a margin account with much more than that. But for our purposes, we’ll start at that baseline.
When the margin account is all set up with $2,000 in funds at your disposal, it’s usually possible (depending on the brokerage) to borrow the full amount of a stock’s purchase price. So that $2,000 can give an investor the ability to buy $4,000 worth of stocks. In its simplest form, that’s the power of margin trading.
When Trading on Margin Goes Wrong
When trading on margin, an investor can buy more securities because they’re not using only their own money. They’ve invested their own money and borrowed the rest from a broker. If that money is invested in a stock, it’s tantamount that the stock price go up. Because if it doesn’t, it’s possible to lose even more money than the initial investment.
For example, if our investor with $4,000 to invest saw the share price of the stock he purchased drop 70%, the account’s total equity could be deemed too low. In turn, the brokerage can issue a margin call. This is to cover the deficiency in margin and return the funds in the account to the minimum value.
But that’s not the worst of it. No matter how much the stock’s price falls, the margin trader is still on the hook for interest on the margin loan. On top of that, the brokerage has the ability to sell all of the investor’s shares to fulfill the margin call. In this case, it could lead to a complete loss of that initial investment. On top of that, the interest on the margin will continue to accrue until paid back. And if the total debts aren’t covered by what the brokerage received from selling those shares? Well, our investor will eventually have to pay that back as well.
On top of all this, a brokerage is fully within its rights to increase the minimum account balance at any time. And it doesn’t have to let you know in advance. This can lead to a sudden need to deposit more funds in the margin account. It can also lead to the brokerage issuing a margin call and selling any or all of the securities in that account.
The Upside of Trading on Margin
As you can see, margin trading can go sideways fast. So you might ask why anyone in their right mind would take on this kind of risk. Well, as high as the risks are, the benefits can be just as high. After all, plenty of smart investors use margin trading to their advantage.
For this example, we’re going to up the stakes a bit. Let’s say our investor deposits $10,000 into their margin account and plans to use it all to invest in Apple (Nasdaq: AAPL).
To make this as easy as possible to follow, we’ll say shares of Apple are trading for $100. So our investor takes his initial $10,000 deposit and pairs it with $10,000 in margin borrowed from the brokerage. This allows him to pick up 200 shares of Apple.
The beauty of this is that if Apple climbs up to $150 a share, our investor will have nearly doubled his money… instead of having just garnered a 50% win without margin.
You see, without margin, our investor would have turned $10,000 into $15,000. A solid investment for sure. But by margin trading, our investor is able to turn his initial $10,000 into $30,000. After paying the initial $10,000 back to the brokerage, he’s left with $20,000 minus the small interest rate on the initial line of credit issued.
For an investor bullish on a given stock, margin trading is an excellent way to magnify upswings in value. This is especially true when using short-term trading strategies. Swing traders can use margin trading to radically increase returns on market trends they spot. It’s a great tool for those focused on cyclical stocks as well.
The Bottom Line on Margin Trading
Just about every investment opportunity out there is about managing risk while trying to maximize reward. And margin trading is no different. In fact, margin trading can be a risk management tool in its own right.
Those with limited funds can use margin to better diversify their portfolios while making it possible for them to be more opportunistic. A margin account can also be a valuable source of flexible financing. And on top of that, margin can beget more margin. If marginable stocks in an account increase in value, it’s possible to leverage the value of those securities for additional margin loans. As opposed to adding more cash to a brokerage account, the increased value of a portfolio can be used as collateral to purchase even more shares on margin.
But do be careful. Margin trading can be a slippery slope. So be sure to never take on more risk than you can handle. And this is especially true when investing with someone else’s money.
About Matthew Makowski
Matthew Makowski is a senior research analyst and writer at Investment U. He has been studying and writing about the markets for 20 years. Equally comfortable identifying value stocks as he is discounts in the crypto markets, Matthew began mining Bitcoin in 2011 and has since honed his focus on the cryptocurrency markets as a whole. He is a graduate of Rutgers University and lives in Colorado with his dogs Dorito and Pretzel.