Did you know that the stocks that you already own could play the part of the collateral for the next ones? You read that right! You can do this with margin trading. When you do not have enough money to buy a stock that you feel is going to skyrocket – you can always choose this option. So, would you choose to do this kind of trading? But remember, when you decide on margin trading – make sure you know the entire picture.
Here we can find out what margin trading is and learn it in-depth for better skills.
What is the Meaning of Margin Trading?
Margin trading entails qualifying for a loan against your existing stocks in order to purchase more shares. This could theoretically improve your profits, but there are hazards associated. Learn how margin trading works and the risks associated with it so you can decide if it’s good for you.
Here is an example of Margin Trading
Any new investor in the market could use the margin calculator online and find out how much interest they would be paying here. This will let you know if you can afford it. But, to make it easier for you – just look at how margin trading works with an example.
Consider an investor who wants to buy 200 shares of a firm that is now trading at 30 a share but only has 3,000 in the brokerage account. He decides to pay for half of the stock (100 shares) with cash, and he buys the remaining 100 shares on margin with a 3,000 loan from his brokerage business for a total initial investment of $6,000.
Let’s imagine the stock price increases by 33% to 40. That means his 6,000 investment has grown to over 8,000 in value. Despite the fact that he must repay the borrowed funds, he is entitled to the profits that he made as a result of their assistance. In this example, he ends up with 5,000 after returning the 3,000, a 2,000 profit. His gains would have been around 1,000 if he had merely invested his 3,000 in cash.
The investor doubled his profit with the same amount of capital by trading on margin.
However, not every investment pays out. In a losing situation, the stock takes a knock and falls from 30 to 20 per share. His investment decreases in value from 6,000 to 4,000, leaving him with only 1,000 after repaying the loan – a 2,000 loss. His losses would have been half as much if he had merely invested his cash at 1,000.
What if the stock price plummets to, say, 10 per share? Although the overall investment is now only worth 2,000, the investor still needs 3,000 to repay the loan. He owes an additional 1,000 even after he sells the remaining shares to pay off the loan. That’s a total loss of 4,000 (his initial 3,000 investment plus an additional 1,000 to meet the loan’s criteria).
Yes, you read that correctly. It is quite possible to lose much more than your initial investment while utilizing leverage.
Cons of Margin Trading
You would also want to be on the lookout for the risks that are mentioned below:
- Being compelled to accept losses. If you have to sell shares to pay a margin call, you won’t be able to hold on to stock to see if it recovers from a loss.
- Taxes are triggered by short-term sales. To avoid a greater short-term capital gains tax payment, investors trading in a taxable brokerage account should examine which shares of what stock they put up for sale. Remember that if the broker is in charge of bringing your account up to the broker’s margin requirements, you have no control over which stocks are sold. (On the bright side, interest on margin loans may be tax-deductible against investment income in some situations.)
- Your credit score has taken a hit. If you fail to return the loan according to the conditions of the contract, much like a traditional loan, it might result in a negative record on the borrower’s credit report.
- Losses are more likely to occur. Buying on margin, as shown in the example above, can result in you losing more money on a deal than if you just used the cash you had on hand.
Now, you know that there are risks involved in margin trading. But, if there is something you could do about these risks? Wouldn’t that be great?
You actually can – you can take some precautions.
Risk Mechanisms for Margin Trading. Before you Start – Do This!
You need to take up these risk mechanisms – and it would not be like you are living on the edge.
1) If you’re trading intraday on margin, you’ll need a stop loss. You can’t enter into a position and then put your stop loss in at a later time. It must be included in the order. More significantly, you must stick to your stop-loss discipline and avoid attempting to average positions if the market moves against you.
2) The second thing to remember about margin trading is to maintain profit booking discipline. Profit is what is booked in this business; everything else is just book profits. Continue to churn your capital and aim to shorten the time it takes for your vacancies to be filled. That is your strongest defense against market turbulence.
3) When using margin money, stay away from stocks that are overly volatile or too static. You run the danger of losing money in any case. A stagnant stock will barely move, yet your interest bill will continue to rise. In the event of volatile equities, your losses can occur in either direction.
4) Assume responsibility for your margin trading situation. Don’t rely on the broker to close the position because the broker will employ a program to do it. In that situation, you might not be able to receive a fair deal. Set a time limit for yourself and stick to it. Take responsibility for your margin trading holdings and, more importantly, monitor them.
5) Do not enter a margin funding position without first assessing the cost and effective breakeven point. In addition to interest, there are other costs associated with margin funding, such as administration fees, DP fees, and processing fees. Consider the statutory cost as well, and then calculate the breakeven point. After that, you can decide whether or not the margin funding position is worthwhile.
Every coin has two sides – so does margin trading. But, when you want those high returns, you need to take up some risks that come along. Also, remember, you will have to take up the risks – only with the right kind of expertise.