Margin trading is a trading practice where investors use borrowed funds from a broker and participate in trading of a financial asset which is what acts as the collateral for the loan. Where, margin is the amount of money that is borrowed from a brokerage firm for participating in . It is the difference between the total amount of securities that are kept in the investor’s account and the loan given by the broker. Trading on margins means borrowing money to purchase security. In simple words, purchasing an asset where you pay only a part of the asset’s value and borrowing the rest of the amount from a bank or a broker.
If you are new to trading and willing to participate in margin trading then this article can be of much help to you. Here we have discussed what is margin trading and how it actually works. Check out now!
How Does Margin Trading Work?
Margin trading allows buying of stocks that are unaffordable. The investor decides to pay only a margin amount of the stock’s total value, which is paid in cash or shares. The process of margin trading allows investors to access bigger capital for investments that facilitates leveraging positions in the market through cash or securities. The broker is the one who funds various margin trading transactions for the investors. The margin is later settled when the investor squares off their position.
This type of trading helps investors earn maximum profits on trades that are successful.
The cost price of the loan varies from broker to broker. Also, margin loan rates differ too and can be as low as 1.6% or as high as 8%. In the US, the margin loan rate is set in accordance with the federal funds rate and changes over time.
Purchasing on Margin
When you buy on margin, you borrow money in the form of a loan from a broker for purchasing stocks. Margin trading allows buyers to purchase more stock than usual. Margin trading is done using a margin account, which differs from the regular cash account.
As per law, the broker must have your consent to create a margin account. The margin account can be a separate agreement or a part of the standard account opening agreement. The investor needs at least $2,000 to make the first/initial investment to open a margin account; however, some brokerages may need even more initial investment. This amount is called the minimum margin. Once the margin account is opened, an investor is eligible to borrow up to 50% of the stock’s selling price. When you deposit this borrowed selling/purchase price, it is called the initial margin.
It is not necessary to borrow up to 50% of the selling price, and you can even borrow just 10% or 25%. However, it is important for you to know that few brokerages require investors to deposit more than 50% of the purchase price.
Investors can keep the loan with them for as much time as they want, provided they meet all the obligations, such as paying interest on the borrowed amount on time. Once the stock is sold in a margin account, its proceeds are received by the broker against the repayment of the loan till it is completely paid.
Another important term is the maintenance margin, which signifies the minimum account balance that you need to maintain before you are forced to deposit more funds or sell stock to repay the loan. A margin call is made when your brokerage puts forth a demand to deposit money in your account in order to reach it to the required minimum level. If you fail to make the margin call, your brokerage has the right to shut any open positions to bring the account to its required level. The brokerage firm doesn’t need your permission to do this and has the liberty to liquidate any positions they want.
Not to mention, the brokerage firm will charge a commission for the transaction. The investor is responsible for any losses that occur during the process.
Different trading platforms offer different sets of rules and leverage rates. For example, in the stock market, 2:1 is the standard ratio, while futures contracts are usually traded at the ratio of 15:1. In the crypto market, the ratio of margin trading is usually between 2:1 and 100:1.
Margin trading is used to open long as well as short positions. A long position is a belief that the price of a certain commodity, stock, or crypto will rise in the future, whereas a short position is an assumption that the price will decline. When the margin position is open, the assets work as collateral for the borrowed money. This is important for traders to know as most brokerages have the right to sell the assets if the market goes against their position.
For example, if a trader opens a long position, there are chances that they would make a margin call if there is a drastic fall in the price of the stock. As we already know what a margin call is, we also must know that if a trader fails to respond to a margin call and maintain the minimum balance, his assets will be liquidated to cover the losses.
How Does Margin Trading Work in Cryptocurrency Markets?
As we know, margin trading carries more risks than regular trading; however, it is even riskier in the cryptocurrency space. As the crypto markets are highly volatile, traders should be extra careful with margin trading. Therefore, margin trading is not recommended for beginners, even though it comes with numerous risk management strategies.
Though you can identify trends, examine charts, and know the entry and exit points, margin trading is still risky. However, these can help in anticipating risks in a better way and trade more efficiently. So, before getting into margin trading in the crypto world, we suggest you become familiar with its technical aspects first and get experience in extensive spot trading.
Margin Trading in Mutual Funds
You cannot buy mutual funds through margin trading because of their trading techniques, as these cannot be sold like stocks. Mutual funds can be bought and redeemed through mutual funds houses. The funds’ prices can only be determined once the market closes at the end of the day. This is why mutual funds do not support margin trading.
Benefits of Margin Trading
Besides all the risks, margin trading can also beneficial in the following ways:
- It is perfect for those investors who wish to encash on the price fluctuations in a short time while not having sufficient cash in hand.
- It helps in making better use of securities or stocks lying in the Demat account.
- Margin trade funding increases the investor’s purchasing power and can diversify their portfolio with a wide selection of shares and securities.
- Margin trade funding also boosts the rate of returns on the amount invested.
- It lets you hold on to the equity delivery positions for a long time while avoiding auto square-off for T+5 days.
Features of Margin Trading
Here are the key features of margin trading that you need to know:
- It allows investors to purchase/leverage positions in securities that don’t come under derivatives.
- Securities which are margin-traded are pre-defined by different stock exchanges.
- Only authorized brokers can provide margin trade accounts.
- Investors can create positions against the margin in cash or shares.
- These positions can be carried to N+T days, where N signifies the number of days a position can be carried to and T signifies trading days.
- A margin trade funding account is necessary for utilizing this facility while agreeing with the terms and conditions that go with it.
Types of Margins
There are three different ways to calculate margins under the cash market section of stock exchanges.
- Value at Risk (VaR) – This is the most common way to calculate margin. In this method, the estimation of loss is prepared using the volatility of the stock and price trends. It shows the most anticipated loss percentage that an investor can suffer for shares on one particular day.
- Extreme Loss Margin: It makes up for losses that are expected in conditions when the VaR margin can’t cover up the loss.
- Mark-to-Market Margin: It is calculated by comparing the price of the transaction with the closing price of the share at the end of the trading day.
What is Margin Funding?
Margin funding works for investors who cannot bear the risk of margin trading. There are few trading platforms and crypto exchanges that offer the facility of margin funding. It allows individuals to provide their money for funding the margin trades performed by other individuals.
Margin funding follows a specific set of rules and yields huge interest rates. If a trader agrees to the terms, the fund’s provider can repay the loan with the agreed rate of interest. Also, the risks involved with the margin funds are lower even though the mechanisms may vary from exchange to exchange. Therefore, users should store their funds in a wallet for margin funding.
Risks Involved in Margin Trading
No matter how simple it may sound, margin trading still carries a significant amount of risk. Being risky is the main reason for doing margin trading with a separate account, i.e. margin account. Below outlined are some of the risks associated with margin trading:
- Amplified Losses: Margin trading certainly helps in boosting profits but it can also amplify losses. You can even end up losing more than you actually invested. Most of the time, investors assume that borrowing from brokers is much easier than borrowing from banks. However, they don’t know that borrowing funds from brokers are equally troublesome as banks.
- Liquidation: Brokers have all the rights to take action against the investors if they fail to go with the margin trade agreement. The broker can liquidate your assets to recover the amount if you are unsuccessful in meeting a margin call.
- Minimum balance: The investor is bound to maintain a minimum balance in their accounts all the time. If the balance falls below the minimum, then a broker will ask the investor to maintain a sufficient amount. In case of failure to maintain the minimum balance, the investor is asked to sell a number of assets or even all the assets they hold to maintain the minimum balance amount.
Practices for Good Margin Trading
Following are the key practices that you must take note of while opting for margin trading:
- Invest wisely: As we know that margin trading can result in profit or loss, we should be extra cautious while going for it. We should never invest in an amount we cannot afford to lose. Let’s understand this with an example. If you borrow $1000 to buy stocks worth $2000, you must be aware that any losses that may occur will be multiplied by 2. Therefore, you should only invest if you have enough money to withstand a move against you and are able to meet a margin call.
- Borrow for a short time period: A margin loan works like any other loan, and you are liable to pay an amount of interest on it. Therefore, it is advisable to pay off the loan as soon as possible, as the longer it takes, the higher will be the interest that you have to pay.
- Borrow less than the maximum allowed amount: An investor must refrain from borrowing the full amount of money that is allowed. We suggest you always start with investing a smaller amount and later increase it once you gain confidence in taking risks, thereby making profits.
Is Margin Trading Good for You?
When you think of margin trading, you should always consider your investment goals as well as the risks associated with margin trading. Margin trading offers many benefits but you need to remember that it can bring both profits and losses. Therefore, you should always give it a shot if you can keep calm in volatile situations and have high-risk tolerance. It is not recommended for investors who cannot stand well against risks.
Margin trading works well for short-term trading in certain situations. Assume if you have reliable information about a firm that might affect its share prices. In such a case, you will be able to make good profits through margin trading. Therefore, you should not opt for margin accounts for long-term trading.
To conclude, margin trading is the kind of financial trading that increases an investor’s purchasing power by offering more capital to invest. However, it involves a lot of risks too. Therefore, as an investor, you should be careful while purchasing on margin and should not invest in an amount that you cannot afford to pay back or lose.
Also, an investor should strategically plan for events like a margin call. If done efficiently and carefully, margin trading can prove beneficial in many ways, such as increased profitability and portfolio diversification.