Margin Trading, How Does it Works? Guide + Risks Involved

margin trading

Margin trading involves using funds from a third party to trade assets. In a successful trade, a huge capital will result in hefty profits. In most cases, traders lack large sums of money to conduct a significant trade.

In such scenarios, having a margin account comes in handy.

You are able to get a ‘loan’ from a broker and trade with substantial funds. The lender uses the assets in your trading account as collateral for the offered funds. The concept is somewhat similar to purchasing a house via a mortgage.

This practice is applicable in Forex, cryptocurrency, commodity, or stock markets.

When to Use Margin Trading

As part of being a disciplined trader, you should use margin trading moderately and only utilize it when necessary. Don’t forget that the margin is a loan that you have to repay with interest!

When engaging in margin trading, you are hoping that your returns will be higher than the amount you need to pay the broker. If the earnings are lower, you will have to reimburse the lender through the amount in your trading account or your own pocket.

Only use this strategy when you have effective risk management tactics and a practical trading strategy. Whether the market is extremely volatile or not, failing to use a low or moderate risk strategy will result in you experiencing the ‘wrath’ of margin trading.

Margin vs leverage

Margin and leverage are often confused with each other. However, the two are actually different terms. Leverage refers to the amount of buying power that one gets when he takes an investing loan. They are often shown in ratios such as 1:100 and 1:30.

Margin, on the other hand, refers to funds that are required to sustain a leveraged trade. For example, if you have $10,000 and you use a 1:30 leverage, the broker can decide to set your margin at $3,000. In this case, if the broker will stop the trade when it falls to $3,000. This is known as a margin call.

Margin Call

A margin account needs to have a certain amount of funds depending on the broker. The lender uses the amount as collateral for the margin. If you incur huge losses, the account’s balance will reduce and the broker may require that you top up the funds.

The broker’s demand to deposit additional funds to meet the required amount is referred to as the margin call. In severe cases, you may have to empty your margin account or even add more money from your pocket to meet the set requirement.

Importance of margin trading

There are several benefits of margin trading. Some of these advantages are:

  • More profits – With margin trading, one can make more money than when trading without. For example, if you have $100, you can only buy a small portion of gold. With a 1:100 account, you can buy more gold.
  • Diversification – A margin account is essential in diversification since you can buy more assets with the borrowed money.
  • Higher returns – If the situation is going on well, trading with a margin account can be highly profitable.
  • Easy to access margin loan – It is relatively easy to access a margin loan since most brokers offer it.

How buying stocks on margin works

Margin trading is popular in the stock market especially among hedge funds. These companies borrow huge sums of money mostly from investment banks and then invest in it. When it works well, these funds make substantial sums.

When things goes south, the situation can be catastrophic. A good example of this is Bill Hwang, who ran a home office known as Archegos Capital Management.

In 2020, he made history when he lost over $20 billion in less than a week. Most of these losses happened because of the huge amounts of loans he had taken from banks like Credit Suisse and Nomura.

Practical example

Here is a good example of a margin trade. A stock is trading at $200 and you have $10,000. In this case, you can invest in it without leverage and you will get 50 shares. If the stock doubles, your profit will be $10,000.

On the other hand, assume that you took a loan of $50,000 to buy the stock. In this case, you have $60,000 and you buy 300 shares. If the stock doubles to $400, your new capital will be worth $120,000. You return the $50,000 you borrowed and you are left with $70,000.

Is Margin Trading a Good or Bad Idea?

Margin trading is not necessarily a bad idea. In fact, it is a good idea if used wisely. As a trader, view it in the same light as fire – a good servant but a bad master. If you use it when necessary and in moderation, you are likely to amplify your profits.

However, you utilize a high risk strategy, you may incur unimaginable risks if the market moves against your predictions.

Here are some of the aspects that make the use of margin a good idea.

Increased purchasing power

This is the key advantage of margin trading. Trading with margin enables a trader to control a larger position than what his/her finances could have allowed.

Increased flexibility

Trading with margin enables you to build your portfolio. With limited funds in your trading account, you may only open one position as a time.

However, margin allows you to open several trades simultaneously. As such, you are able to trade in different assets in a day.

Ability to expand your trading account

Trading with little funds makes it difficult to manage a position or day trade several instruments. A margin allows you to trade in various markets throughout the day; an aspect that will increase your profits and grow your trading account to a size that is easier to manage.

Start Small and Become a Successful Trader!

Risks Involved

While margin trading is a good idea, there are certain risks that a trader should understand before engaging in the practice. Just like before, here are some of the risks involved.

Increase in probable losses

If the market moves as you had predicted, you are bound to make hefty profits when trading with margin. However, the opposite is also true. If your market predictions fail, you will incur immense losses.

Margin call requirement

This is one of the risks that a trader should be aware of before engaging in margin trading. In case of a huge loss, you may have to part with a large sum of money to fulfil the set terms of the margin.

Probable liquidation

If you fail to honor the terms of agreement provided for the margin, the broker has the right to take the funds in your margin account.

Difference Between Margin Trading and Short Selling

Margin trading and short selling are two risky trading strategies. On the one hand, margin trading involves obtaining funds from a broker in order to manage larger positions than your finances can allow. The amount in your margin account acts as collateral to cater for the borrowed amount as well as the resultant interest.

On margin, a trader hopes that the market will move as he/she had predicted in order to acquire earnings that exceed the ‘loan’.

Why Short is different

In contrast, short selling involves using a margin account to sell assets that you don’t own. A trader will borrow such an asset as a share from a broker or bank and sell it on the market.

After the closure of the short position, the trader buys back the asset and returns it to the lender to settle the borrowed amount.

To engage in this strategy, the trader predicts that the prices of the asset in question will fall. If his/her predictions are right, he/she will make a profit by buying the asset a lower price and retaining the additional amount after the settling the lender’s ‘loan’.

Final Thoughts

Margin trading is not a bad trading strategy. In fact, it can rake in huge profits if used when necessary. However, there are various risks involved in this trading approach. As a disciplined trader, use it in moderation and ensure that you have an effective risk management model.

External Useful Resources

  • What Is a Margin Call? – TheBalance
  • Is margin trading a good idea? – Quora
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