What Is It, and What You Need to Know About It: Margin Trading

this is what u need to know about it, and what it is: Margin Trading

Most investors will move monies from their checking account to their brokerage account and then utilize those funds to purchase stocks (or mutual funds, bonds, and other securities). But, of course, there’s more than one solution to this problem.

What is margin trading?

• What is often referred to as “buying on margin” is a kind of margin trading in which an investor borrows money from their broker to purchase stocks. Leveraged investing involves borrowing money to invest in stocks and then paying back the loan plus interest later.
• Purchasing on margin offers several advantages over paying with cash, but you should be aware that a higher level of risk comes with the potential for enormous profits. One way that investors increase their earnings is through leverage, such as in margin trading. However, it also implies that losses might be amplified if the investment does not perform as expected.

Buying on margin example

• Consider a scenario in which a trader has $3,000 in her brokerage account and wants to buy 200 shares of a firm selling at $30 a share. Instead, she uses that money to pay for 100 shares outright and borrows $3,000 from her broker to cover the cost of the remaining 100 shares, for a total first investment of $6,000.
• In this scenario, the share price increases by 33% to $40. It implies her original $6,000 investment is now worth almost $8,000, She must repay the loan, but she gets to keep any profits it generates. After giving back the $3,000, she has $5,000, a $2,000 gain. She would have made back about one grand if she had put all three grand into cash investments.
• With margin trading, the investor could quadruple her initial investment with the same amount of cash.
• In reality, however, not all investments succeed. If the worst-case scenario comes to pass, the stock price will fall from $30 to $20 per share. After repaying the loan, she is left with only $1,000 (a $2,000 loss) since the value of her investment dropped from $6,000. Even if she had lost $2,000, it would have been less if she had invested her cash solely.
• What if the stock price continues to fall, to $10 per share, for example? The investor needs $3,000 to repay the loan, but their current investment value is just $2,000. So she still owes $1,000 after selling the remaining shares to pay off the debt. That’s a total loss of $4,000 (her initial investment of $3,000 + $1,000 more since the loan had to be repaid as agreed).
• That’s not a misprint. However, using leverage increases the risk of losing more than your original investment.

Margin Amps Your Gains … and Losses

How margin trading works

• As shown by the preceding example, margin trading has a high risk and may be very costly for investors who need more experience and resources to manage the loan. Therefore, let’s get into the specifics of margin loans, beginning with a few of the most crucial features:
• An investor’s collateral serves as a security deposit in a margin loan, just as it would in the case of a secured loan. A loan is secured by the value of the investor’s account assets, including cash and investments like stocks and mutual funds. To borrow on margin, most brokers demand that their clients always have a minimum of $2,000 in liquid assets in their accounts.
• The investor’s borrowing cap is calculated from the acquisition price of the asset plus the collateral’s worth. For example, an investor may borrow up to 50% of a stock’s purchase price from a broker, capped by the amount of collateral in the account. Let’s say you wish to buy $5,000 worth of stock and use $2,500 as a margin. To borrow the additional $2,500 on margin, you must first have sufficient funds in your account (“initial margin”) to pay $2,500 in costs.
• Interest is added to a loan just like any other loan. The loan’s interest rate is determined by the broker, who starts with a base rate and adjusts it up or down, depending on the loan amount. The margin interest rate decreases in proportion to the margin loan’s size. For example, one prominent brokerage estimates that in 2020, investors who borrow between $10,000 and $24,999 will pay an effective interest rate of 8.70%, while those who borrow between $100,000 and $249,999 will pay an effective rate of 7.45%. Margin Balances earn interest every month. The margin loan must be repaid in full before any other debts may be paid off using the sale profits.
• The devil, and the risk, are in the details, and margin loans aren’t quite like regular loans.

What are maintenance requirements and margin calls?

• After the documentation for a conventional loan (such as a mortgage) is signed, the asset’s value does not influence the loan’s conditions.
• Having your property appraised for less than you paid because of slow home sales in the area and the algorithm on your preferred real estate search engine is nothing more than a paper loss. The financial institution will keep your loan terms and require you to reapply. The lender will only take possession of your vehicle and sell it for cash if you sell your home.
• Nevertheless, if mortgages functioned like margin loans, a homeowner would be in precisely that situation.
• In contrast to mortgages, the value of an investor’s collateral (the cash and securities in their brokerage account) is always tied to the amount of money they have in that account at any one moment with a margin loan. To keep their margin loan in good standing, investors must have a certain amount of cash and securities, known as the “maintenance level” required by their broker.
• The broker may issue a “margin call” if the value of the securities falls below the maintenance level, which may occur if any of the stocks in the portfolio declines in value, including the equities acquired on margin.
• Investors then have a few hours to a few days to add enough money to their accounts to keep them open. She may accomplish this by adding to her cash balance in the account or by selling stocks (or closing option contracts).
• If the margin call deadline is missed, the broker may sell some or all of the client’s stocks and other assets to cover the shortfall.

Other risks of margin trading

• Do you get anxious thinking about a margin or maintenance call coming up? To feel that way is very understandable.
• The volatility of stock prices puts investors at risk of their portfolio values dropping below their maintenance requirements. Moreover, according to the small print of most margin loan agreements, a brokerage company may increase the maintenance demand at any moment with little to no warning.
• Margin calls and falling short of the required minimum maintenance level may result in various sticky financial situations for investors.
• Lock in losses despite resistance. Margin calls necessitate immediate stock sales, eliminating any chance of profiting from a stock’s potential recovery.
• Profitable short-term sales usually result in a tax burden. Therefore, investors using taxable brokerage accounts should carefully select which stock shares to sell to minimize their short-term capital gains tax liability. To add insult to injury, if your broker is responsible for selling shares to meet margin obligations, you have no control over which shares are sold. (On the bright side, the interest you pay on your margin loan can be deductible from the profits you make from your investments.)
• Poor investment loan conditions. Like with any loan, the numbers will only add up in your favor if the return on your investment is higher than the interest rate you’ll be paying.
• Negative marks on your credit report. Like a traditional loan, it might hurt your credit score if you don’t pay back your installment loan on time.
• The threat of suffering more losses. The above example shows how using a margin while purchasing may lead to a more significant loss than if the trader had used all available funds.

Handle with care.

• Like credit cards, margin loans provide the benefit of instantaneous borrowing power. Margin trading may increase earnings and provide access to new market possibilities, but only for individuals willing to take on the associated risks and have substantial investment expertise. Ensure you receive a margin loan once you fully understand the risks.
• The writer’s bio: Former NerdWallet retirement and financial expert Dayana Yochim. Forbes, Real Simple, USA Today, Woman’s Day, and the Associated Press highlighted her work.