There is no doubt that in the game of investing the returns you get is dependent on the amount you put in, so the opportunity to leverage on a bigger investing capital is an appealing one. But is trading on margin a good idea?
Trading on margin is a good idea if you are aware of the risks and how to protect your investment, but it could be catastrophic if it leads you to risk more than you can cope with. Investing itself is a risky game, with or without margin.
Surely, you would like to know the advantages and disadvantages of trading on margin, but first, let’s find out what exactly is trading on margin.
- Leverage Trading Strategy (Margin Call, Risk, Ruin, Performance)
- What is the optimal capital allocation in trading?
- What is the risk of ruin in trading? (Probability of ruin and loss)
What Does Trading on Margin Mean?
Trading on margin means buying or selling an asset with only a part of the capital needed for that transaction, while the broker or the exchange takes care of the rest. In other words, you are borrowing money from the broker or the exchange to make up the amount needed for the trade.
Generally, in the stock market, the broker lends you the money required complete the trade, but in the futures market, it is the clearinghouse of the exchange that covers for that balance. To trade stocks on margin, you must open a margin account rather than the usual cash account.
In the US, the law requires that you open a margin account with a minimum of $2,000 and must provide at least 50% of the amount you intend to invest (initial margin). If the trade is making money, your part of the invested capital (trader’s equity) will be increasing, but if it’s losing money, your part will be decreasing. All through the life of the trade, your trader’s equity must not fall below 25% or whatever maintenance margin your broker chooses.
So, in other words, the initial margin is the amount you need to open the position, while the maintenance margin applies after you’ve entered the trade.
Day Trader Pattern Rule
One particular rule that applies to any trader with a margin account is the pattern day trader rule. In short, this rule imposes some limitations on margin accounts with less than $25 000. However, the day trader pattern rule only restricts daytrading activity, and will not be an issue if you’re looking to hold your positions overnight!
Here you can read more about the pattern day trader rule.
Let’s now have a look at the advantages of margin trading!
Advantages of Trading on Margin
As you can imagine, trading on margin can offer you a lot of benefits; these are some of them
1.Higher potential returns
When you are trading on margin, you are scaling up the size of your position in the market. In other words, you are leveraging on bigger position size. The initial margin and leverage have an inverse relationship. The lower your initial margin, the higher the leverage and the higher your potential return. So if your initial deposit is 50% of the total cost of a trade, you can make twice what you would have made on a cash account.
If you are trading on margin, you can potentially free up some funds which can be used to buy other investments and diversify your portfolio. For example, let’s say you want to invest in 10 stocks and intend to put $2000 on each stock, but you have only $10,000. With a margin account, you can do that, but you can’t possibly achieve that with a cash account.
5.More dividend income
Dividends are paid per share. The amount of dividend you get from a company is dependent on the number of shares you have in the company’s stock. Since trading on margin helps you buy more shares, you also stand to earn more dividend income if the stocks you buy pay dividend.
6.Easy funding for new opportunities
There are times you may see a stock trading on discount and want to buy the stock, but you don’t have enough cash to do so. A good example is the employee stock option plan. In such a situation, if you’re operating a margin account, you can easily borrow from your broker to buy the stock.
7.Relatively low interest rates
The interest rate on margin accounts may be cheaper than borrowing money from the bank, and it’s definitely cheaper than using a credit card cash advance.
8. Convenient repayment schedule
Provided your equity doesn’t fall below the maintenance margin, you can hold the loan for as long as your trade lasts, and repay when you close your trade.
Disadvantages of Trading on Margin
Expectedly, where there is a potential reward, there is also risk. These are some of the disadvantages of trading on margin:
1. Higher potential losses
There’s no way to know for sure if a trade will go in your favor. It is possible for a trade to go against you right from the beginning. When this happens, your losses will be magnified because you are trading on margin, just the same way your profit increases when a trade is moving in your favor. With a 50% margin, your losses would be twice what it would have been with a cash account.
2. Paying interests
Trading on margin means taking a loan, which comes with an interest, and you must pay the interest whether you are making profits or not.
However, this does not apply to futures, for which you don’t pay an interest rate. This is because a futures contract is a contract to buy or sell an asset at a future price, which means that you don’t hold the asset right now
3. Getting a margin call
The nightmare of a margin trader is getting a margin call from the broker. A margin call is a request from the broker for more deposit. You will get a margin call if your trader’s equity falls below the required maintenance level. If you are not able to meet a margin call, the broker can liquidate some, or all, of your position to protect his money. That is, you will be brought out of the trade since your account balance cannot cover the initial margin.
Margin Trading in Stocks VS Margin Trading in Futures
Although they are similar in some ways, margin trading in stocks is fundamentally different from what happens in futures trading. In stock trading, the trader is buying an asset (stocks) right away, but the money in his account is not enough to complete the transaction, so the broker lends him the rest. But the broker will require that the trader comes up with a certain percentage of the capital first — initial margin.
However, in futures trading, because the asset is not changing hand at the moment (futures is a contract to buy or sell an asset on a future date), the clearinghouse of the exchange covers the cost of the contract but will require collateral (margin) from the trader. This also means that there is no interest rate on futures.
If you want a better explanation of futures, why not have a look at our guide to futures contracts!
Difference in Leverage
Apart from where the loan is coming from, they also differ in the way they are regulated and how much leverage a trader can use. To open a margin account with a stockbroker, a trader must deposit at least $2,000 which constitute the minimum margin. There’s no official minimum margin in futures trading: different brokers offer different account types. While some may require $10,000 to open an account, brokers who offer micro-accounts can accept $500.
In stock trading, regulation T of the Federal Reserve Board limits the initial margin (the minimum amount a trader must initially commit to in a trade) to 50% of the total cost. So a stock trader can only get 1:2 leverage. In futures, the initial margin requirement varies with the exchanges and type of contract, but it’s usually about 5% or 10%. This means 20x or 10x leverage.
Furthermore, the minimum maintenance margin in stock trading is 25% of the total market value of the investment, but in futures, the value varies with the type of contract. Since futures contracts are marked to market (settled daily based on the price of the underlying asset), a futures trader may be required to pay a variation margin on a daily basis.
Trading on margin is beneficial if you understand the risks but can be dangerous if you risk too much. As a loan, you have to pay the interest irrespective of how well the investment is performing(unless it’s a futures contract). So a profitable position can still be a losing investment.