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How To Know When Trading On Margin Is Right For You

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How To Know When Trading On Margin Is Right For You

Most new traders know these feelings — the denial, anger, grief and acceptance that comes after tallying up the numbers from a seemingly successful day of trading only to find your closing balance is far below your expectations. There are plenty of reasons this can happen — a lack of planning or tracking during trades, expectations scaling at a faster rate than positions or holding on to a strategy that no longer works as well as it once did.

Whatever the case, once profits have plateaued, it can be a harrowing process for traders to correct course. While new traders will bump into these problems, they’re not exclusive to novices. Long-term traders can often find their way through those times in the red by simply gaining more experience and modifying their trading strategy.

Margin accounts are one recourse that some traders have used to quickly amplify the effectiveness of their positions. Trading using margin, which is essentially a cash loan provided by a broker that uses stock purchases as collateral, increases the amount of shares traders can afford on any individual trade, amplifying their potential profits. This is referred to as buying power.

Traders can open a margin account by depositing an amount of their own funds, usually above a required minimum that varies from broker to broker. That deposit serves as a portion of their investment on a trade. The broker then adds up to 50 percent of the shares purchased to the trade. Once the shares are sold, the trader pays back the borrowed funds plus a percentage of the returns as interest.

For example, if you used $10,000 to purchase shares of a stock priced at $100, you could buy a maximum of 100 shares. If you deposited that same $10,000 into a margin account, your maximum buying power increases two-fold to $20,000 because the broker will generally fund up to 50 percent of the purchase, allowing you to purchase 200 shares.

Now, say that same stock rises in value by 5 percent and you decide to sell. The initial 100 share investment will show a return of $10,500, a $500 profit. Alternatively, the 200 share investment will show a $21,000 return. Subtracting the $10,000 that was borrowed from the broker and you then have $11,000, a $1,000 profit (minus the interest on the margin loan).

Think of it this way: the increased buying power allowed the same $10,000 investment to double in profit. That additional $1000, if kept in the margin account, also increases the traders buying power as he or she can now borrow up to $11,000 from the broker.

However, it’s important to keep in mind that trading on margin poses greater risks in addition to greater rewards. If that trade had turned the other way, and the stock had fallen by 5 percent, that margin account would have similarly lost twice as much. That loss is entirely on the trader in addition to any interest accrued over the holding period. For this reason, most traders only use a portion of their allowed margin on a given trade and tend not to hold a margin position for too long to avoid losing their profits to interest payments.

If a trade blows up while investing on margin, a margin call can happen. A margin call occurs when the amount the trader deposits within the account falls below the broker’s designated minimum. Unless the account is brought up above the minimum, the account enters a margin call. This means that the broker may demand the account holder sell some of his or her assets to raise the required amount of funds. It is a situation traders should do all they can to avoid.

While margin calls are not rare, they can be avoided through careful planning, intelligent use of margin and not overextending your buying power. Margin is most useful for short term positions or day trades, which minimize the total interest on the loan.

I want to stress that margin isn’t a silver bullet to maximum profit, and it is not a tool that works for every trader. However, used effectively, margin can pad some of your positions and boost your capital for future trades.

Disclosure: Warrior Trading is an editorial partner of Benzinga

Posted-In: Warrior TradingEducation Markets General

 

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