If you’re a trader, you know that trading on margin fuels some incredible money-making opportunities. On the other hand, if you’re a beginning trader, the prospect of trading on margin could scare the pants off of you, or your reaction could be completely the opposite. It could cultivate a burgeoning excitement or curiosity.
While everyone’s initial response and ensuing experience are different, there are some commonalities that everyone who trades on margin experiences.
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What is margin trading?
When you buy on margin, you borrow from a broker to purchase stock using a special margin account with that particular broker. Buying on margin allows you to purchase more stock than what you’d otherwise be able to buy with just the funds in your account. Ultimately, doing so ramps up your buying power.
If you’ve read a little bit about margin trading, you might see another word bandied about, and that word is “leverage”. Note that margin is not leverage. In fact, margin allows you to leverage the funds in your account to enter larger trades. Leverage is expressed as a ratio. A 3:1 leverage, for example, means that you would be able to hold a position that is three times the value of the amount in your trading account.
How does margin work?
Individual brokerage firms will offer you a list of accounts that are marginable. Most brokers require at least $2,000 in equity in order to access margin through that particular broker.
How does margin work, anyway? Fidelity’s website offers a great example of how margin specifically works:
Obviously, stock prices could drop when you’re trading on margin, too, and here’s a great illustration of how that can impact your account on TD Ameritrade’s website:
Pros and cons of margin trading
As with any type of trading you’ll do, there are pros and cons, but margin trading could offer a heightened nail-biting scenario if not done correctly.
Pros, or benefits, include:
- The most positive benefit to trading on margin is the maximized potential returns because of leverage.
- More trades are available and offer more diversification because of the amount of buying power you have while trading on margin.
- You can employ more advanced strategies.
- You have more trading flexibility.
- Interest on margin loans could be tax deductible against your net investment income.
Cons, or risks, include:
- It’s inherently risky to trade on margin, and you could lose your initial investment, plus what you borrowed.
- Trading on margin involves additional costs through the broker in the form of interest on your loan.
How to manage risk
Trading on margin isn’t for everyone. It’s important to carefully evaluate your risk tolerance and ability to trade on margin based on your financial resources.
The prospect of losing money through leverage is a major risk, as previously discussed. Maintenance call risk is another type of risk, and what happens when your account’s securities fall below the minimum maintenance requirement. Margin calls are required to be paid immediately, so it’s imperative that you leave a cash cushion in your account to reduce the risk of a margin call.
In addition, the more research you can do to try to minimize risk on your account, the better off you’ll be. Thoroughly research the securities you’re considering.
Where to start margin trading
Most major brokerages offer some form of margin trading – even some of Benzinga’s picks for the Best Online Brokerages. Here’s a quick peek at some of our favorites.
All brokerages have different margin rates, so learn all about interest rates for margin accounts at all the brokerages you’re considering or wherever you already have an account. You’ll also want to pay close attention to account minimums as not to incur any fees or barriers to trading. If you’ve done the research and can afford to take a risk, then margin trading may be right for you.