Margin trading can be a great way to increase your returns in the stock market. It allows you to borrow money from a broker to purchase stocks, giving you the opportunity to invest more money than you have in your account. However, margin trading also carries a certain level of risk, and it’s important to understand how it works before taking the plunge.
In this beginner’s guide to margin trading, we’ll go over the basics of margin accounts, how they work, the pros and cons of margin trading, and how to get started. So whether you’re just getting your feet wet in the world of investing or a seasoned trader looking to expand your portfolio, this guide will give you the information you need to make informed decisions about margin trading.
What is Margin Trading?
When you use a margin account to buy stocks, you are taking out a loan from your brokerage firm to increase your buying power. This allows you to buy more shares than you otherwise could if you were only using cash in your account. The amount you borrow for each purchase is called the “margin.”
The ratio of your collateral to the amount of that margin loan is what determines what type of account you have. That’s why it’s important to understand how your margin account works. Margin trading is different than buying on a credit card or with a loan from a bank because of where the money comes from.
When you buy stocks on margin, you’re borrowing the money from your brokerage firm rather than a bank. And while buying stocks on credit is never a good idea, there are rules in place to make sure that you don’t overextend yourself or fall behind on payments.
When you buy stocks on margin, the broker can liquidate your assets if you don’t make your payments on time. And as long as you keep your margin account open, they can keep adding to your debt. One of the biggest advantages of margin trading is that you don’t have to pay interest on the money you borrow. That said, you do have to make timely payments on the amount you borrowed, or you could get in trouble.
How Does Margin Trading Work?
Each brokerage firm has its own rules for determining when to put you into a margin account, but typically, if you are margin trading, you will be charged interest on the loan you take out. This fee is based on the Federal Funds Rate, which is a benchmark rate that determines how much banks charge each other for loans.
The other factor that determines whether or not you’re placed in a margin account is the leverage ratio. The leverage ratio is the percentage of the total value of your account that is borrowed. For example, if you have $10,000 in your account and you borrow $3000, your leverage ratio would be 30%. This will vary between brokerage firms, but the general rule is that the higher your leverage ratio is, the higher the interest rate you’ll be charged.
Pros and Cons of Margin Trading
There are both pros and cons of margin trading that you should be aware of before making a decision to use a margin account. One of the obvious advantages is increased buying power. This can be particularly useful if you want to buy a big position in stock but don’t have enough money in your account to buy the full amount.
Another advantage is that if the stock goes up, you can make more money from the investment, as you’re borrowing money to buy more shares than you otherwise could. For example, let’s say you own 100 shares of a stock priced at $50 per share. If the stock appreciates to $100 per share, you’ve made a nice 50% return on your investment.
But if you were just using cash from your account to buy 100 shares at $50 per share, your return would only be $500. Margin trading allows you to buy more shares than you otherwise would be able to. It’s important to keep in mind that while there are advantages to trading on margin, there are also some significant risks.
Getting Started with Margin Trading
If you’ve decided that you would like to start margin trading, the first step is to open a margin account. Margin accounts are typically not available to individuals who are new to the stock market. In most cases, you will have to have been trading stocks for a certain amount of time before your brokerage firm will allow you to open a margin account.
If you’re just getting started in the world of investing, there are other ways to increase your buying power. One option is to simply use the cash in your account to buy more shares than you would normally be able to if you were only using cash. Another option is to open an account with a Robo-advisor like Wealthsimple.
Robo-advisors do not require you to have a certain amount of money in your account to start investing. The downside is that you won’t be able to use leverage to buy more shares than you otherwise could with a margin account.
Margin Account Requirements
Before you open a margin account, you’ll have to meet certain margin account requirements. The first and most important requirement is that you have at least $2000 in your account. Because you’re borrowing money from your broker, they need to make sure that you have enough cash in your account to cover the loan.
The second margin account requirement is that you have a brokerage account that is at least six months old. Most brokerage firms will require you to have had the account for six months before they’ll even consider putting you in a margin account.
The last margin account requirement is that you have a consistent trading history and a good track record of successful trades. Your brokerage firm will likely have a minimum amount of time that you have to have been trading before they’ll consider putting you in a margin account.
Margin Account Fees
Another thing to keep in mind when opening a margin account is that you will have to pay a fee. The amount you’ll have to pay will depend on the amount you borrow and the interest rate at your brokerage firm. The good news is that the fee is typically a one-time charge, although it could be charged monthly or quarterly depending on the brokerage firm.
Depending on the brokerage firm, the fee could be as little as $25 or as much as $100. The fee is meant to ensure that your broker will be able to get their money if you don’t pay off the loan. That said, most brokerage firms will allow you to trade on margin if you have a negative balance in your account.
The fee is just a way for the brokerage firm to make sure they’re able to get their money if you don’t pay off the loan.
Margin Trading Strategies
As with any type of investing, it’s always wise to do your research before making any moves. That said, there are some general strategies that you can use when trading on margin. For example, you might want to avoid opening a margin account if the stock market is in a downtrend.
This is because stocks tend to fall faster when they’re in a downtrend, and margin accounts are often liquidated when the value of your stocks in your account falls below a certain level. Another example is that it can be easier to exit a position when trading on the margin because you can sell shares in your account without having to find a buyer for the actual stock.
This can be helpful if you need to get out of the stock quickly because it allows you to sell other assets in your account to help pay off the loan.
Risks of Margin Trading
As with any type of investing, there are risks associated with margin trading. The biggest risk with margin trading is that you could get a margin call. A margin call occurs when the value of the stocks in your account falls below a certain level.
This is when your brokerage firm will issue a margin call, which means you have a set amount of time to add money to your account to bring the value of your stocks above the margin call level. If you don’t meet the deadline, your brokerage firm can liquidate your assets in your account to pay off the loan.
It’s important to remember that when you’re trading on margin, you’re taking on more risk than you would otherwise. While there are advantages to trading on margin, you have to be careful and make sure that you don’t overextend yourself.
Tips for Successful Margin Trading
There are a few things to keep in mind when you’re getting started with margin trading. These tips can help you avoid common mistakes that can lead to bad decisions and ultimately poor returns on your investments.
Avoid Over-leveraging
The power of leverage is both a strength and a weakness of margin trading — it’s what makes it such an attractive tool to increase profits and hedge risk, but also what makes it risky and potentially dangerous. Leverage is the amount of funds borrowed to make a trade, measured as a percentage of the total value of the trade.
So, if you have $10,000 in your trading account and use 10% as a margin, you have $1,000 in funds borrowed. You may want to consider reducing your leverage to 25% as a good rule of thumb — this way you’ll still have $2,500 in borrowed funds, but it won’t be as risky.
As a general rule of thumb, if you’re not sure about the potential downside of a trade, you should reduce your margin. If you’re unsure of the potential upside, you should increase your margin.
Use Stop Losses and Take Profits
Stop losses and taking profits are essential tools for risk management in any investment strategy. They help you manage your risks when trading on margin by automatically selling (or “closing out”) your positions when they reach a certain price.
Margin trading with stop losses and take profits in place can protect you in the event of a sudden, unexpected market correction or shift in sentiment. Using stop losses and take profits can also help you manage your margin, as they provide a safety net if your positions lose value and your margin is reduced.
Make sure to use stop losses and take profits at the appropriate levels — they should be in line with your risk tolerance. Otherwise, they won’t help you manage your risk.
Keep Your Margin Levels High
One of the best ways to avoid a margin call is to keep your margin levels high. Margin levels vary from broker to broker, but typically you should keep your equity above 30% to avoid margin calls. Some brokers may even require equity above 50%. If you’re margin trading frequently, you may want to keep your equity above 50% to ensure you meet margin requirements.
Avoid Margin Trading During Volatile Markets
Margin trading can be a great way to boost profits during a bull market. However, it can be extremely risky to engage in margin trading during a volatile market. This is because the price of individual securities can shift significantly in one day, and margin trading requires that you keep your equity above a certain percentage.
If the price of your securities decline, you may not be able to meet the margin requirements and could be forced to sell your positions. During volatile markets, it can be extremely difficult to identify the bottom, which can lead to significant losses.
Margin Trading Courses
If you’re interested in exploring the world of margin trading, it’s recommended that you take a course to learn the fundamentals and best practices. There are a number of courses available, including:
These courses provide an overview of the basics of margin trading, including what it is, how it works, the benefits and risks associated with it, and the strategies and techniques to use when trading on margin. They’re a great place to start if you’re interested in learning the fundamentals of margin trading.
Margin Trading Software
If you’re serious about trading on margin, it might be a good idea to invest in a trading platform. Margin trading platforms are designed to make it easy to enter and exit positions, track your margin and equity levels, and manage your portfolio. Some of the most popular trading platforms include:
All of these platforms offer the ability to trade on margin, and they’re all suitable for beginners. To help you decide which one is best for you, it’s a good idea to compare them. You can find reviews and comparisons of these types of trading platforms online.
Margin Trading Services
Margin trading services, also known as third-party margin providers (TP Markers), are companies that facilitate margin trading and provide collateral. If you don’t have enough funds in your account to trade on margin, you can use a margin trading service to borrow funds. These companies work similarly to banks and provide loans to investors who want to trade on margin.
One of the most popular margin trading services is TD Ameritrade. To use TD Ameritrade’s margin trading service, you’ll need to open a margin account. Margin trading involves risk and rewards, just like any investment strategy.
However, it can be an effective way to increase profits and hedge risk if you have the right knowledge and approach. It’s important that you understand the basics of margin trading and the best practices for using it successfully. By following these tips, you’ll be well on your way to becoming a successful margin trader.
