What is margin trading?
Margin trading means borrowing money from a broker in order to buy and sell securities. Margin trading gives you an opportunity to enter the market with a bigger amount of money than you actually have. To get additional money you use leverage.
Margin trading increases the amount of funds you have. So, if you have a profitable trade, you will earn more. However, if you lose, your losses will increase as well. And risks to meet a margin call with a stop out will rise significantly.
How margin trading works?
You can trade on margin when you don’t have enough cash to trade the entire volume that is required. To do this, you open a separate margin account with your broker and make an initial deposit called the minimum margin. This minimum margin serves as a cushion of sorts in case your positions don’t close as planned. In other words, margin is the equity an investor has in their brokerage account. This equity is used as collateral for trading with bigger capital.
When your margin account is fully set up, you can start trading and borrow money from your broker. Still, it’s important to understand that you can’t ask for any sum you want. There are limits on the amount of money you can borrow for each position, so you will have to pay up to 50% of the price of your chosen stock with money from your margin account. This means that you can actually buy twice as much stock as you could’ve afforded with just your cash.
Then, when you finally close the position you opened earlier on your margin account, you repay the amount you borrowed from your broker, including the interest.
What are maintenance requirements and margin calls?
As can be expected, margin trading has special requirements all traders must fulfill to be able to use their margin account. One of such requirements is called maintenance margin. Maintenance margin is the minimum amount of equity that you should have in your margin account after buying stocks. Different brokers set different maintenance margins, but the minimum amount is considered to be at least 25% of the total value of the stocks currently trading in a margin account.
But if the value of the stocks falls below the maintenance margin, you will get a margin call. A margin call is a warning that a broker gives you when account equity drops to a certain level. What to do after the margin call? You either close the losing order or add money to your account.
And if you don’t do that and your account equity depletes even more, you’ll get hit with a stop out. Stop out is the final part of your losing trade when it will be closed because your account equity falls to the lowest allowable level. In this case, your positions will be automatically closed until your maintenance margin amount is back to the viable level.
Other risks of margin trading
On the one hand, margin trading is a great opportunity to earn more money when you don’t have enough cash to trade on your own. On the other hand, margin trading can turn sour if the price of your chosen stock moves in a direction unfavorable for you. Thus, you’re under a huge risk to not only lose your money, but also get into an enormous debt with your broker.
Moreover, as was already mentioned earlier, your broker can close your positions and sell your stock without consulting you if your maintenance margin falls below the required amount. In addition to that, you might also have to pay interest on your positions that are no longer trading.
Buying on margin example
Let’s say you have $5,000, but you’d like to buy $10,000 worth of stock, so you open a margin account. Your broker lends you another $5,000, and now you have twice as much stock as you could’ve bought with just your cash. If your stock goes up in price, you can sell it and enjoy nice profit after repaying the money you borrowed from your broker.
But if the price drops and your stock starts to trade at $7,000, your maintenance margin will be left with only $2,000 after subtracting the amount borrowed from the broker. What’s left is less than the minimum requirement for a maintenance margin (at least $2,500), so you will now get a margin call for $500 that you must deposit into your margin account to prevent your positions from being automatically closed.
2022-08-24 • Updated