What is margin trading? What are its risks? How does it differ from day trading?

Margin trading allows investors to borrow funds against their stock holdings. The borrowed amount is called margin or leverage. This means that the investor has less capital at risk. If the price of the security falls, the lender can sell his shares and take a loss. In contrast, day traders don't borrow money. They invest their own cash and hope for a profit.

In today's blog post I will be covering everything you need to know about margin trading. Let's start with what exactly is margin trading?

What Is Margin?

Margin is the amount of money you deposit to protect yourself against losing money on investments. When you buy stock, you are borrowing shares from someone else. You pay them interest—a percentage of the value of the shares—to borrow those shares. If you sell the shares, you must return the borrowed shares plus the original investment plus whatever interest you owe. This is called paying off the loan.

When you invest in stocks, bonds, commodities, real estate, or anything else, you are making a long-term loan to the company or person selling you the asset. To cover your risk, you make sure there is enough money in the account to cover what you might lose. That way, if the company goes bankrupt, you don't lose everything.

The margin rule says that you can lend up to 50% of the total cost of the security minus fees and commissions. For example, if you bought $100 worth of IBM stock for $90, you could put up $50 as collateral. That is how much you think it is worth. If the stock drops in value, you still have $50 left over. If the stock rises in value, you keep the profit.

If you use margin, you must pay interest on the portion of the purchase price used as collateral. This interest is usually charged daily.

You can use margin to increase your chances of winning big. But you must watch out for hidden expenses. Some brokers charge high fees for using margin. Others require you to pay taxes on profits earned while using margin. And some companies limit the amount of margin you can use each month.

What Is Margin Trading?

Buying on margin means you are borrowing money to invest. This allows investors to buy shares without having to put down cash up front. If the stock price goes up, you make money; if it falls, you lose money. But there is a big difference between buying stocks on margin and trading stocks on margin.

Leverage increases the amount of returns on an investment while also increasing risk. For example, you may have a trading account with £1000 of your own equity. By using margin at let's say 10:1 (or 10 to 1) you will effectively be able to trade with £10,000.

In this scenario you take on whatever profit or loss the full amount you traded with incurs. To make things easy let's say Company A stock's price is £1000. If you had bought 1 share with your £1000 and the stock went up 10% then you would be left with £1100.

Using the 10:1 margin previously mentioned you could instead purchase 10 stocks at £1000 (£10,000) total even though you only have £1000 starting capital. If the stock now rises the same 10% you would end up profiting £1000. Putting your final balance to your starting capital + the profit = £2000.

Using margin in the example above turned the 10% win into a 100% win. The same occurs in the opposite direction however; a 10% loss, would be a 100% loss on 10:1 margin.

Minimum equity requirement

The minimum equity requirement for margin accounts is typically set by your broker. In most cases, they will allow you to open a margin account with no initial equity. However, if you do not meet their requirements, they may ask you to provide additional funds before allowing you to open a margin position.

To find out the margin requirements of your broker, either contacting them directly or looking on their website should provide this information.

Margin calls

A margin call occurs when there is a discrepancy betweens the current market value of a trader’s portfolio and the amount of cash he has deposited to cover his trades. This happens when the price of an asset declines while the trader still owes money on previous purchases. If the trader doesn't deposit additional funds into his account, the broker will liquidate the assets in his portfolio. These assets could include stocks, bonds, commodities, currencies, ETFs, futures contracts or anything else that can be traded.

There are two ways to handle a margin call: Adding funds to your account, increasing the risk of losing more capital; or allowing the exchange to sell off your position, potentially causing you to lose everything. Margin trading allows traders access to leverage. Leverage increases risk. Traders use margin to increase their exposure to markets without having to put up much of their own capital.

Margin Trading Advantages

Margin trading gives you access to large quantities of stock without having to put up much money upfront. This makes it possible for day traders and professional investors to buy stocks that are too expensive for them to afford otherwise.

In addition to helping you invest in smaller amounts of stock, margin trading also lets you diversify your portfolio. If one investment goes down, another one might go up. You don't have to worry about losing everything because you're invested in several companies.

You can also leverage your margin account to increase your buying power. When you borrow funds against your securities, you become a lender. Lenders make loans to borrowers, who pay interest on those loans. Your broker pays you interest on the amount you borrowed. In turn, you can lend out the same amount again, and earn even more interest.

Margin Trading Risks

Margin accounts are popular among traders because they allow investors to trade large amounts of stock without having to put up cash upfront. But there are risks involved in margin trading. If the value of your portfolio declines, you could lose more than what you borrowed. And if you don't pay off your debt, you'll owe interest on top of that.

Furthermore, margin trading carries other risks. For example, if you borrow $10,000 from your broker and then decide to close your position, you'll need to repay the full $10,000 plus any interest charges. If your position loses value, you'll need to come up with the difference between the original loan amount and the loss.

How To Trade on Margin UK

Margin trading allows traders to use borrowed funds to purchase stocks or other financial instruments. Traders can choose to either spread bet or do cash forward contracts. Spread betting involves placing bets on how prices are expected to move over a set period of time. Cash forward contracts involve buying or selling an asset now and paying later.

To start trading on margin, you first need to find a broker with this functionality. Some UK brokers that allow margin trading include IG Group, Interactive Brokers, Plus500, Fidelity International and Charles Schwab.

Next, you must open a margin account. The minimum initial margin requirement varies by broker but generally ranges from £100-£1,000. After opening your account, you'll need to deposit at least the required amount. Once you've done so, you can begin trading like you would on any other platform with the additional margin feature.

Summary

Margin trading is a great way to get started investing in stocks. By borrowing funds from your broker, you can buy shares of companies that are too expensive for you to afford otherwise. With margin trading, you can diversify your portfolio and gain exposure to different sectors of the market. However, margin trading comes with its own set of risks. Be sure to understand these before starting your trading journey.

I am not a financial advisor and anything I say in my blog is not to be taken as financial advise. For any financial advise please contact a financial professional. My blog is based on my own opinions, research and understanding of the financial markets.

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FAQ

What Is Margin Trading? | Binance Academy

Margin trading is a method of trading assets using funds provided by a third party. When compared to regular trading accounts, margin accounts allow traders to access greater sums of capital, allowing them to leverage their positions. Essentially, margin trading amplifies trading results so that traders are able to realize larger profits on successful trades. This ability to expand trading results makes margin trading especially popular in low-volatility markets, particularly the international Forex market. Still, margin trading is also used in stock, commodity, and cryptocurrency markets.

Source: academy.binance.com

What Are Some Other Meanings of the Term Margin?

Outside of margin lending, the term margin also has other uses in finance. For example, it is used as a catch-all term to refer to various profit margins, such as the gross profit margin, pre-tax profit margin, and net profit margin. The term is also sometimes used to refer to interest rates or risk premiums.

Source: investopedia.com

Why are stop orders important?

A stop order, or a stop loss, is a mechanism that closes an open position when it reaches a certain price that's been set by you. This means that when a trade goes against you, it can automatically be closed before any losses grow too large and lead to the possibility of a margin call.

Source: capital.com