What is Margin Trading?
Margin trading is a controversial topic that has divided many investors. While some believe that margin trading can be used to create a huge upside, others claim that it causes financial ruin for traders.
How can traders like you and I take advantage of margin trading to grow our accounts?
Let’s start by knowing what margin trading actually is, along with what it can and cannot do for you.
Understanding Margin Trading
Margin trading refers to the practice of using borrowed money from a broker to invest. The term “margin” refers to the amount deposited with a brokerage when borrowing money to buy securities.
When buying on margin, the investor uses the marginal securities or cash in their brokerage account as collateral to secure the loan.
The collateralized loan comes with an interest rate that will be calculated periodically and charged.
Let’s take a simple example:
The initial margin requirement of your broker for a certain stock is 60%.
You wish to purchase $10,000 worth of the stock,
Your margin would be $6,000 (and the broker could loan you the rest).
Images provided are not current, and any securities are shown for illustrative purposes only.
How Does Margin Trading Work?
Although we use the term margin trading broadly, there are actually two types of trades involved. Margin traders are capable of using both types depending on their view of the market direction.
Buying Securities With Borrowed Funds
When you expect the price of the asset you’re trading to go up, you can borrow funds from your broker to help you purchase more shares.
However, the assets in your account will be used as collateral, and you’ll have to pay the corresponding interest and fees.
Short Selling
On the other hand, you can also place a trade if you expect the price of the asset you’re trading to go down. This occurs when you borrow securities and sell them, planning to buy them back at a lower price and return them later.
This is also known as short selling. While the shares are borrowed, your assets will be used as collateral. During that time, you’ll also have to pay interest and fees.
Pros of Margin Trading
Increased Buying Power
The most obvious benefit of margin trading is that it increases an investor’s buying power. Margin trading allows you to borrow money, and therefore, you can purchase more stock than you'd be able to normally with a cash account.
Here’s an example for you:
Suppose you have $10,000 in cash, and the market price of a stock is $100.
With a margin of 50%, you can buy 100 shares with your own cash and borrow another $10,000 from your broker to buy another 100 shares.
The shares you previously bought are used as collateral.
Now, you hold 200 shares ($100 per share) through margin trading, and the market value of your position is $20,000.
Images provided are not current, and any securities are shown for illustrative purposes only.
Higher Potential Returns
Increased buying power allows you to buy more securities than you could otherwise afford. The more securities you own, the greater your potential profit if those securities gain value.
Let’s continue the example from above:
If the stock price rises by 50% to $150 per share, the market value of your position becomes $30,000.
Since the funds you borrowed from your broker remain unchanged at $10,000, your equity rises to $20,000.
This effectively gives you a return of 100% on your initial capital of $10,000.
Images provided are not current, and any securities are shown for illustrative purposes only.
Cons of Margin Trading
Despite its potential upside, traders should use margin carefully and be aware of its risks.
Higher Risk
Borrowing money to invest is risky.
There’s no guarantee that an investment will succeed. Whether the securities you buy gain or lose value, you will have to pay back the borrowed amount. In some cases, you could wind up losing more money than was put into your portfolio.
Margin trading is best used by experienced traders who know how to control their risk and are confident of getting the market direction correct.
Interest Charges
Borrowing money isn't free. When you use margin to invest, you have to pay interest based on the amount of money that you’re borrowing.
Before investing in margin, investors should take the cost of it into account. The interest charges reduce gains on successful investments and increase losses from poor-performing investments.
Even if the shares you buy maintain their value, the cost of borrowing money can lead to losses if held for a long time.
Initial Margin & Maintenance Margin Requirements
If you want to trade on margin, you first need to post a certain amount of cash, securities, or other collateral, known as the initial margin requirement.
The current initial margin requirement set by the Federal Reserve Board's Regulation T is 50%. However, some equity brokerage firms may set their initial margin requirement higher.
Once you trade on margin, enough value should be maintained in your margin account to meet the brokerage's maintenance margin requirement (or the margin call requirement), which is usually 25% according to the Federal Reserve Board's Regulation T.
If an investor's portfolio fails to meet the maintenance margin requirement, it could trigger a margin call, which may force the investor to either deposit additional funds or sell their investments.
Many investors fear margin calls as investors may be forced to sell positions at unfavorable prices.
3 Types Of Margin
To help you plan your trades, we will explain the three types of margins. These include your initial margin, maintenance margin, and soft edge margin.
The initial margin is the account equity required to open a position. If you want to buy $10,000 worth of shares with an initial margin requirement of 40%, you’ll need $4,000 of cash.
The maintenance margin is the account equity required to maintain a position. This is typically lower than the initial margin required. If the maintenance margin is 30%, you’ll need $3,000 of account equity (including open positions) to hold the trade.
The soft edge margin is the account equity level where forced liquidation will occur. Typically, a soft edge margin is raised on the day before a non-trading day. It is then lowered when trading days resume. Assuming a soft edge margin requirement of 20-30%, you will need $2,000-$3,000 of equity on a $10,000 initial position.
For moomoo, we have a feature that allows you to monitor your risk of a margin call. Inside our platform, you can always view the risk level of your trading account.
Preparing To Trade On Margin
A margin account is needed if an investor wants to trade on margin.
This is different from a regular cash account. A margin account is a standard brokerage account in which an investor is allowed to use the current cash or securities in their account as collateral for a loan.
Each brokerage would have different requirements to qualify for margin trading and different terms for its services.
A brokerage can also set its own rules on interest rates and how much of your own money you must have in the account compared to borrowed money.
In margin trading, as the investor is using borrowed money or leverage, both the losses and gains would be magnified as a result.
Is Margin Trading Really For You?
In conclusion, margin trading can offer great potential rewards to traders who know how to manage their risk and catch price movements.
However, a trader has to factor in the interest cost and keep enough capital in the account to avoid a margin call.
Traders should be confident in their skills before attempting to trade with margin.
For such traders, moomoo offers margin accounts on our platforms. The amount you can borrow is dependent on the risk associated with each stock.
