Margin trading allows a trader to leverage securities he already owns to purchase additional securities.
During the Roaring 20s in the U.S., confidence in the stock market encouraged many investors to risk ambitious trades in the hope of a sizable score. With the help of margin accounts, investors could risk more money than they had in their cash accounts.
Those who delve into margin trading are essentially borrowing against the securities within their accounts, which can be risky. In 1929, margin requirements were only 10 percent, which may have incentivized investors to buy more than they could afford. When the stock market crashed, brokers called in on these loans, but many of those investors were unable to pay them back. Historians cite this as a contributing factor to the Great Depression.
For those who are adept at trading on margin trading, there is the potential for profits, but margin trading can also amplify losses. Still, understanding how margin trading works can help traders decide if this strategy is suitable for them.
THE BASICS OF MARGIN TRADING
Buying on margin means borrowing from a third party, such as a broker, to finance part of the trade. Margin trading allows a trader to leverage securities he already owns to purchase additional securities.
When a trader initiates a margin trade, the trader must commit part of the total order value. Under the Federal Reserve Board Rule Regulation T, firms can lend an investor up to 50 percent of the total purchase price of a margin security for initial purchases. Traders may use margin trading to open both long and short positions.
- Minimum margin is the initial amount investors are required to deposit into a margin account before trading.
- The initial margin is the amount an investor must pay in cash for securities before the broker can lend capital for the investor to buy more.
- The maintenance margin is the minimum account balance required to keep all trading positions open. FINRA requires a maintenance margin of 25%.
- If the trader does not meet the maintenance margin (usually due to losing trades), he may force a margin call. A margin call happens when the broker asks for more capital or securities to meet the margin requirement.
These requirements may vary depending on the broker. You can view our margin rates on the Score Priority website.
However, investors may not be able to buy every type of stock on margin. For example, many brokers will not allow investors to purchase pink sheets or over-the-counter Bulletin Board stocks because of their inherent liquidity risks.
OPPORTUNITIES AND RISKS
Under the ideal trading circumstances, margin accounts might increase your potential returns. For example, if you invest $10,000 in a stock and receive a 20 percent return, you could make $2,000; if you could have borrowed another $10,000 on margin and bought more stock, you could have doubled your profits.
However, unlike trading with a cash account, traders who use margin trading may see losses that exceed the initial investment. If the investments lose value, margin traders still have to pay back the loan and interest.
Another risk of purchasing stocks on margin is the possibility of a margin call. If the value of the security falls and causes your equity to fall below the maintenance margin, you will need to sell securities or contribute more cash to your account. If you are unable to do so, the brokerage firm can sell the securities in your account which could inflict unanticipated losses and tax liabilities.
TIPS FOR MARGIN TRADING
While the potential access to more trading capital can be tempting, neglecting the risk of amplified losses is dangerous. Inexperienced traders or those with a low risk tolerance may want to avoid trading on margin until they feel more comfortable with the higher stakes.
For those who feel ready, remember to never risk money you can’t afford to lose. The allure of a possible win should not outpace a trader’s protections against a loss. Selecting trades according to a thoughtful trading strategy rather than an impulse may help traders minimize unpredictable moves.
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You should consult your own tax, legal and accounting advisors before engaging in any transactions. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice.
Nothing in this communication shall constitute a solicitation or recommendation to buy or sell a particular security. Accordingly, no representation or warranty, expressed or implied, is made as to, and no reliance should be placed on, the fairness, accuracy, completeness or timeliness of the information contained herein.