Margin Trading: Disadvantages, Advantages & Details
Margin trading (aka trading on the margin) is one of the riskiest strategies you may employ while trading. It’s essentially investment with the borrowed funds, which has the potential to break you completely if you are not careful. However, it also has the potential to bring you huge profits without risking your own money.
That’s chiefly what brings so many people into margin trading – the opportunity to fuel your strategies and schemes with increased capital. Who cares if the funds are borrowed from someone? Your scheme will surely rip exponential gains, and you’ll repay the debt immediately.
It’s obviously a double-edged sword. Let’s examine this strategy thoroughly, then. So, what is margin trading?
Margin Trading Explained
In the usual course of trading, you pay money to buy an asset, wait for it to grow in price, and sell it for more. That’s how most people trade, and it’s a perfectly reasonable approach with its moderate ups and downs.
Trading on margin, by comparison, is a much riskier method. It can bring huge profits, but also proportionally huge losses. It is the case because trading this way doesn’t just mean you can borrow money and be neglectful about returning it. Brokers lay provisions so that you would be forced to pay back if you aren’t even anywhere near broke.
You have to create a special account to be able to trade on borrowed funds. They usually admit you to the club if you have a good-enough trading history and some funds and securities in your normal account. If you have a margin account, they can give you a loan, but only in proportion to the actual funds you want to commit to margin.
This proportion is called ‘leverage’, and different brokers offer different leverage ratios. 1:100 (your funds to margin) is common enough, but there are also huge ratios of 1:1000, 1:10000, and more. Don’t try them; it’s not a good idea. Even 1:10 is more than enough. The rest is just goose chase – not worth the trouble.
Many brokers have their own margin accounts. They are additional accounts where you can manage your margin funds. Usually, you’ll need some experience and background with the broker if you want to sign up for some margin trading. Some less-than-trustworthy brokers give it to just about anyone, which is a sham.
If you are given a margin account, you’ll need to do the following to start margin trading:
- Deposit a sum of money to this account
- Pick a leverage option to decide how much money you want to borrow
- Receive your borrowed funds
- Start trading.
Now, the minimal amount for most certified American brokers is $2,000. So, if you deposit a minimum amount and pick leverage of, say, 1:1000, you’ll have $2,000 of your own money + $2,000,000 from the broker. This amounts to $2,002,000, and you probably see why it’s not too feasible.
The $2,000 in itself is a sizeable sum in the right hands, and you basically take a huge bonus from the broker that you’ll need to return. The percentage of your own money in this vastness is minuscule. It creates a giant rift between your actual resources ($2,000) and what you can do now with two million.
Opting for 1:10 is a much more reasonable option. Considering that you need to first earn at least $2,000 to start margin trading, it means you already have some experience, and an additional $20,000 will do you good if you have a sound strategy of spending them.
In addition to your own funds and the leverage, the usual margin funds consist of another chief part. Perhaps, it’s actually more worthy of attention than the other two because it needs to stay intact no matter what.
This part is called margin maintenance, and it’s basically a bail that you can’t move anywhere until you paid back your debt. In America, it legally comprises 25% of the full margin. So, if you end up having $22,000 with the 1:10 leverage, it could be broken into:
- $2,000 trader funds
- $20,000 margin
- $5,500 maintenance
If it doesn’t add up, then it’s correct. You can allocate the maintenance to each part however you wish, but your account always has to have one dollar above $5,500. What it means for you is that the actual usable money you borrowed is only worth $14,500. The rest should be given to maintenance.
Whatever you do, the ultimate usable margin will be much smaller than what you have in your margin account. So, if you wanted to invest a specific amount of money, you might want to deposit a bit more capital so that the margin would grow proportionally to finances that you can actually use for trading.
What if I go below the maintenance?
Going below the maintenance level is one of the worst things that can happen to you if you have already lost the money you borrowed from the broker. If you spend more than what the minimum allowed value is worth, you’ll receive a margin call from the broker.
Margin call states that you need to replenish the supply of money back to the maintenance point within several days. If you do that, the margin call is nullified. If you fail, the broker may start to forcibly sell the shares in your possession to pay back the debt.
If you are currently in the middle of a lucrative trend, you can try negotiating the situation, but more often than not they’ll just sell whatever you have when the time is up. That includes the stock you bought with the margin, so you have to be careful and make sure you have just enough maintenance.
Other dangers of margin trading
There are other risks associating with this sort of investing, besides just maintenance. Some of them include:
- Margin interest. You need to pay various sorts of interest regularly after you take on debt. The funniest thing is that they can pay the interest using your maintenance if you don’t have anything else on balance.
- Expiration date. Many assets acquired on margin have an expiration date. If you don’t close the position before it, you’ll have to close the position.
- Premium options. If you are trading options on margin, you’ll have to pay double the premium for safety.
There are many more additional costs for various types of products. The broker usually provides a list of assets that can be traded on margin, alongside the specific costs they made up for each sort. Margin trading is not a stroll in the park, as you see, because you are very much responsible for borrowing money.
The biggest threat to your sanity is still the interest. The exact rate can vary based on the type of product, the size of the margin, and other requirements. It can also change dynamically in some cases. In short, you need to be sure you have more money on balance to cover the interest costs.
Actually, you might want to reduce your actual usable margin even more to delegate a portion of money solely to interest.
Advantages of margin trading
Some of the more apparent disadvantages are obvious. But after so much talk about issues with margin, what about benefits? There are a few very tangible benefits, actually.
- Proportional winnings
Many people forget that your winnings increase exponentially alongside your investments. So, if you invest x100 money than you wanted before, you won’t receive x100 profits once the position proves fortunate. It’s much more than that, and that’s precisely the reason people take on debts.
If their intuition results in a successful trade, it means they can repay the debt and pocket many times its size. Without the margin, the profits would be exponentially smaller. A successful margin position means you receive a lot more money without losing anything.
The broker usually provides several leverage options: from 1:10 all the way to 1:1000 and even beyond. It means you receive way more opportunities to invest. If it turns out the stock you were aiming for all this time is even more of a sure win, you can take on a bigger debt to win even more from a safe bet.
However, it’s very risky, and you shouldn’t do it without enough expertise or additional funds to repay the debt in case of emergency.
Disadvantages of margin trading
The disadvantages are much more prominent. Although margin trading is not inherently a losing gamble, it is extremely risky, hence the downsides.
- Huge potential losses
If the position you chose proved detrimental, it often means you’ve lost most or all of your borrowed funds. With smaller leverages, it can be helped. However, with leverages of 1:100 and more, the debt becomes an unbearable burden. Not only do you lose the capital, but you’ll also likely provoke a margin call.
In turn, the broker will have to sell your property on the exchange just to reach the maintenance level. That won’t free you of the debt – it’ll still need to be repaid.
- Higher difficulty
Margin trading is generally regarded as an advanced trading method. Simply to start margin trading, you must accumulate $2,000 at least. It’s a relatively small sum for the market, but in order to gain even that, you need to spend some time on the exchange and make a few good calls.
Consider also that you have a lot more than just $2,000. The debts can go as high as several million (if you have a decent history with the broker, that is). What would a beginner do with so much money?Yes, I want access to free training