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What is Trading on Margin
What is Trading on Margin
Have you heard the term “trading on margin”?
Ever wondered what it meant?
The short definition (for those that want to know what it is without all the boring math details.)
Trading on margin is nothing more than buying stock with debt.
Want more information? Keep reading:
A Little History:
Buying stocks on margin has been around for a while. In fact, it was a big factor in how far the market crashed during the Great Depression.
At the time you could buy stocks on margin with very little of your own money. When the market began to crash, many were not able to cover margin calls and had to then sell stock.
The selling of the stock, caused the prices to continue to drop and trigger more margin calls. It became one big downward spiral. Many of today’s limits exist because of this fallout from the Great Depression.
The Details On Margin Trading:
- If the price goes up on the stock you purchased on margin, your return goes up.
- If the prices goes down, your losses will also be bigger.
- Margin Call – when the value of a stock drops enough that it triggers the need for you to add more cash to your account. If you do not have the cash to add, then they will sell your stock to cover the difference. (This can be done without permission, so read your agreement for the rules).
- The amounts you are allowed to borrow are limited by the government. But your brokerage might put higher limits in place.
- Must deposit at least $2,000 into your account at most firms.
- You may borrow up to 50% of the purchase price of the stock. This is the initial margin.
- Must keep a minimum amount of equity in your account, after the purchase. The equity is the value of the securities minus how much you owe the brokerage firm. The law is 25% of the total market value of your securities must be in the account. This is the maintenance margin.
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Not all stocks are eligible to be traded on margin. Typically the stocks not eligible are thinly traded stocks or volatile. Think penny stocks and IPO’s!
- Interest might be tax deductible – check with your CPA.
- A Margin account is a brokerage account that allows you to use margin. You must apply to have your account set-up with margin. It is not standard on your brokerage.
- When you hear someone say they are trading on margin or margin trading it simply means that they are using debt to invest.
The Math of Margin Trading:
Let’s look at the math of trading on margin by looking at an example of how much cash you have invest with and what your return is. Both of these using margin and not using margin.
If you buy a stock for $20 and the price rises to $30 then your return is 50%.
Now let’s say that instead you wanted to buy the stock with margin instead of using all your cash. Based on the 50% guideline, you would put in $10 per share and the brokerage would lend you the rest.
When the stock then proceeds to go to $30 your return is 100%. Don’t forget you would still need to payback the loan and the interest.
Now let’s look at that exact same case, but with a loss of $10 instead of a gain. With a cash purchase you would lose 50%. With the margin purchase you would lose 100%, plus interest and commissions for the trade.
This is what a margin call would look like:
If you have a security on margin that has a value of $30,000 that you borrowed $15,000 on. If the stock drops to $20,000 then you would have 25% in equity ($20,000 – $15,000)= equity of $5,000. $5,000/$20,000 = 25%.
This is not enough for a margin call. But if the value dropped to $18,000 you would only have equity of $3,000 and would get a margin call on the extra $2,000.
Is Margin Trading for You:
If you are new to investing and don’t know the basics of the stock market the answer is definitely no!
Margin trading which is also known as using leverage is for the advanced investor.
If you decide you want to give it a go, make sure you read all the details from your brokerage. Most companies will have this information available to you without first filling out the application. If this is not the case, call customer service and find out the details.
Once you understand what your brokerage companies rules are, it is time to fill out your application. Most companies do this all on line. Again, if you need assistance, call customer service.
After you submit your application they will review it and determine if you qualify for a margin account. If you do, they will add it and you can begin using it right away.