What is a Margin? What Is Margin Trading? All the answers and more in the article below:
Credit is a simple fact of our day-to-day existence whether we like it or not. Though debt and the obligation to pay the debt, in its many forms, is not something one necessarily enjoys doing -- it is an important function of our economy and allows the smooth flowing of money and transactions.
These are the very things that create jobs, pay for the creation and growth of businesses, and keep the lights on wherever in the country we go. But few ever actually consider that credit can also be traded.
In simple terms, because of these things -- one can buy or borrow stocks and securities with money he or she doesn't have and still profit from it.
Many seasoned and sophisticated investors do this for a variety of reasons and reap great rewards because of it.
These are called margins and, for your education and if you might actually want to use this method of trading, we have compiled all the need-to-knows about the subject below.
By the end of this post, you'll have an understanding of the following:
- What A Margin Is, and how to easily understand it
- What Margin Trading Is
- Examples & Other Uses of Margins out
That being said, let's get started!
What is A Margin?
To put it simply, a margin is the amount of equity (or money that can be borrowed) in an investor's account.
This is the amount that can be used as credit to purchase stocks or securities.
Margin trading is a way to buy into the stock market when you only have part of the money. This is helpful because you can use your account statements and decision-making skills to make trades with less risk than if you had full ownership of the stocks. Margin traders are usually in high-risk industries like investor relations, treasury management, or fixed income.
When one says "to margin" or buys something "on margin" it means that the investor has borrowed money from his or her brokerage or exchange -- more than what they have in their accounts.
It is considered credit but, where other types of load require collateral, the collateral of the loan took out from the brokerage to buy securities is the cash you have deposited with them.
In the event where your securities fail to earn enough to pay off your loan at the very least, the brokerage is entitled to use the money deposited.
There are also interest rates that are applied periodically -- this is how the brokerage profits from such an endeavor. There are various reasons why an investor might want to do this -- such as the ability to acquire more stocks and securities that he or should could have otherwise.
These are things that must go directly into the investor's considerations when calculating whether or not purchasing a security on margin is worth it or not.
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What is Margin Trading?
Margin trading is a way to buy into the stock market when you only have part of the money. This is helpful because you can use your account statements and decision-making skills to make trades with less risk than if you had full ownership of the stocks.
The current cash deposited with the brokerage or exchange forms the collateral for the loan.
Investors use these kinds of credit to buy more stocks and securities than they could with just cash.
Leverages from the loan can either prove to be more profitable or more costly depending on the outcome of the securities traded. One such practice is taking a short position with stocks purchased on margin. The rate of return expected by the investor on the investment should be much higher than the costs involved with the loan itself.
One can only engage in margin trading using a margin account which is different from a standard account. A broker is legally obligated to ask for permission before opening a margin account and the minimum deposit for a margin account is $2000 -- known as the minimum margin.
Usually, you can borrow up to 50% of the amount deposited but, note that many simply borrow 10-25% at a time.
It should also be noted that there are rules for the minimum amount of balance one must maintain to continue having a margin account -- this is known as the maintenance margin.
All that considered though, you can keep your loans as much as you like so long as you regularly pay off the interests. Doing so will allow the return and all your investments to come back nice and clean of deductions.
Examples of Margin Trading
Though in principle, the concept of margins and margin trading seems simple enough, let's use a simple example for you to better grasp how investors use them in their favor.
- Imagine that you open a margin account with a 60% initial margin.
- There is a stock out there that costs $100 that you wish to buy because you feel it will be very advantageous in the near future. Since you have an initial margin of 60%, then you can buy $60 on margin and borrow the rest from the broker.
- You can also choose to buy the rest with your current money to minimize the cost of charges and interest associated with loans.
Another important thing one must picture is the amount of buying power one has with a margin account.
- For example, you have $5,000 deposited in your margin account.
- If you were to set a purchase price up to 50%, you actually have $10,000 to purchase various stocks and securities. Even if you bought securities that cost $2,500, you would still be left with a purchasing power of $7,500 and you still haven't tapped into your margin yet.
- You would only be buying on margin when your purchases exceed $5,000.
Note that sometimes, a brokerage might also charge commission on transactions which raises the cost of operating a margin account.
So, although a margin account increases your overall purchasing power, it also exposed you to a lot of costs and payment requirements that need to be accounted for. This places more pressure on the securities you buy to be profitable.
Other Uses of a Margin
Though it comes with its own set of risks, margin accounts have found application outside of securities trading. Their ability to increase the owner's purchasing power while still earning the brokerage interest in the form of commission and interest rates makes them great financial instruments in several situations.
Margin is also a term used in other fields of finance but can mean different things:
1.) Uses in Accounting
In accounting, the margin refers to the difference between expenses and the revenue of a company or business. It either be referred to as gross profit margins, net profit margins, or operating margins -- depending on the computation.
This bears little resemblance to the kinds of margins used by traders but, since such terms are thrown on the trading floor constantly, it helps to know the difference.
2.) Uses in Mortgages
A margin in mortgage lending refers to the amount -- usually fixed -- that is added into an index to adjust it to the period of time.
This is simply to adjust the index rate to keep up with the effects of inflation.
Things to Keep in Mind
Like with any loan, as time progresses the interest rates and charges tend to pile up -- making them very costly as time goes by.
Important: When operating a margin account, it is good practice to only use it for short-term investments with carefully calibrated returns that garner you profit and cover the charges of the account.
If you keep investments one margin for too long, you're gonna need much more return just to break even.
There is also the all too present risk of your investments going south and resulting in a loss. In bad investments such as these, you might use up your entire collateral or worse, end up actually being in debt to the brokerage.
Note also that not all securities can be purchased on margin. The Federal Reserve Board has placed certain restrictions on stocks that can be marginable and outright prohibits some securities from being bought on margin.
These can include:
- Penny Stocks;
- Over-the-counter Bulletin Board Securities;
- and Initial Public Offerings.
This is due to the risks present in the stocks day-to-day which make them far too volatile to buy on margin. Brokers and brokerages also have their own respective rules and preferences with regards to the stocks they are willing to buy on margin.
Brush up on the rules and regulations of both the brokerage and The Federal Reserve Board before doing anything related to margin trading.
The losses and gains incurred with buying things on margin are amplified.
This can either be a good thing or a bad thing depending on the outcome of your investments -- this is why only seasoned investors participate in this kind of investment.
On one hand, you have a perfectly good setup that allows you to purchase more stocks than the money you actually have on hand can allow. Your increase in purchasing power affords you the ability to invest more and, as a consequence, earn more from those investments.
Alternatively, the costs associated with such an account can put a dent in your profit potentials and can even result in losses. It gets even worse when one takes into account that the securities and investments being bought themselves come with their own set of risks. That is the securities and/or stocks bought on margin can prove to be costly mistakes.
This method, like with any other investment tactic, requires a serious weighing of the pros and cons along with enough experience that one has a handle on the market. Doing so will certainly minimize the risk while allowing for greater appreciation of the rewards.