Risk And Advantages Of Margin Trading
Have you heard of the stock market crash of 1929? Did you know that unregulated margin trade was one of the main causes of the collapse? Margin trading is like bodybuilding on steroids! It’s a double-edged sword. However, while informed about its risks and advantages, a trader can use the strategy to their advantage to accumulate wealth, not just riches.
Margin trading allows you as a trader to leverage securities you already own to buy additional securities, access line of credit, or short securities. Talk about the three powerful pillars of margin trading.
This article will go in-depth on the risks and advantages of margin trading to allow you to make a sound decision if it’s worth the risk. Before discussing the dark side of margin trading, let us see how it works to your advantage as a trader.
Opportunity to leverage assets
If you wish to boost your financial muscles to take positions that you wouldn’t have taken with your existing cash, then try margin trading. Like a rocket, it will boost you to the next level, depending on how you use it.
How does margin trading leverage an asset? When you buy securities on margin, you can increase the size of your investment by leveraging the value of securities you already own. If your investment’s value rises, you can potentially increase your returns.
Investors can borrow up to 50% of the value of a securities purchase using margin under Federal Reserve Board Regulation. For example, if you wanted to buy $1000 worth of stock, you could put $500 of your own money down and use a margin loan to buy another $500 worth of stock, totaling $1000. Easy, right? Don’t get hasty and make your decision based on that just yet.
Ability to profit from a share price decline
Short selling is a complex strategy in which an investor attempts to profit from a falling stock price. To shorten security, you must first borrow stock from a brokerage firm, which requires that you have a margin account approved.
After borrowing shares, you sell them and then repurchase them at a lower price at a later date. Your profit would be the difference between the proceeds of the original sale and the cost of buying back the shares.
Assume that after conducting your research, you concluded that Company X would be unable to meet its revenue targets due to a successful new product launch by X’s main competitor. You then borrow 100 shares of X stock from your margin account and sell them short at $100 per share for a total of $10,000. Keep in mind that this doesn’t include commission charges.
X’s stock price has dropped by 20% to $80 in six months. So you buy 100 shares at $80 each, return them to your brokerage firm, and pocket the $2,000 difference (minus commissions, margin loan interest, and any taxes). This is how margin trading can allow you to leverage your assets for financial gain in the stock market.
Allows you to diversify a concentrated portfolio
You may be putting too many eggs in one basket if your portfolio is dominated by a large block of stock from one company. You might be able to use those shares as collateral for a margin loan if you have a margin account. You can diversify your portfolio with the loan proceeds instead of selling your original stock. This strategy is especially useful if you have a large unrealized capital gain that you want to keep.
A convenient line of credit
You can take out a margin loan after your account has been approved for margin borrowing. There are no additional forms or applications required. This easy access to cash can be useful in a variety of situations, such as when you are unemployed, have an unexpected medical bill, or need cash for any other reason. You can write a check if your brokerage account includes checking.
It gives traders the ability to take part in advanced option strategy
You can place advanced options orders on equities, ETFs, and indexes, such as spreads, butterflies, and uncovered options, if you’re approved for both a margin account and options trading.
Flexibility in repayment
You can repay your loan whenever you want, as long as your debt does not exceed your margin maintenance requirement.
It makes it easier for employees to participate in a stock option plan
Some employers may give employees stock options. This allows you to exercise an option to buy a stock at a lower price than its current value. You must have sufficient funds to purchase the shares to use these options. You can use the securities in your margin account as collateral for a loan to cover the cost of exercising your options if you have a margin account. This allows you to avoid either selling securities and incurring a taxable capital gain or exhausting your cash reserves.
With potential reward comes potential risk. Margin loans can be useful and convenient, but they are not without risk. Margin borrowing carries all of the risks that come with any debt, such as interest payments and a reduction in future income flexibility. Leverage and margin call risk are the two main risks of trading on margin.
Risk of not meeting a margin call
Depending on the types of securities you own and whether you borrow money to buy more shares or sell short, your brokerage firm will require you to maintain a certain percentage of equity in your account.
Equity is calculated by subtracting your margin loan balance from the total value of your account to reflect your ownership interest. For example, if your account’s securities value is $20,000 and your margin loan balance is $15,000, your equity is approximately $7,000, or 33%. The minimum equity maintenance requirement for stock positions is typically 30%, but it may be higher depending on various security or account factors.
Your account may be subject to a margin call if the value of the securities you’re using as collateral for your margin loan falls below the minimum equity maintenance requirement. As a result, to increase your equity, you’ll need to add cash or securities to your account. In addition, your brokerage firm may sell securities you own without notifying you to increase the equity in your account if you do not act quickly.
Margin works in both ways. It can magnify your profits and losses depending on the leverage you use.
Margin trading can only work to your advantage when you have the discipline to follow a strategy you have in place. It’s in no way a get-rich-quick strategy. Use the information in this article to help you curve your way to mastering your trading strategy rather than a get-rich-quick strategy.