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Margin trading is an investment tool that can yield a huge profit if executed correctly. The key to margin trading is leverage--using borrowed money to purchase an asset. When successful leveraged or margin investments are made, the gains are magnified. However, like every other investment opportunity I have discussed on this site, it also has risks. And since trading on margin has such high potential rewards--you guessed it--it also has high risk. So when investments go bad, the use of margin also magnifies the losses. Using margin trading is not recommended for many investors. Novice investors or investors lacking the temperament that leveraged trading demands should not use margin. To trade on margin, you need a margin account which is different from a regular cash account in which you trade using the money in the account. By law, your broker must obtain your signature to open a margin account. Your signature may be obtained as part of your standard account opening agreement or may be a completely separate agreement. Typically, an initial investment of at least $2,000 is required for a margin account. This deposit is known as the minimum margin. Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. You should think of margin trading as a loan from your brokerage to help you buy more stock. You should also know that like a loan, you will be charged interest and be required to post collateral (the shares purchased). If you understand leverage the implications are immediately obvious. For example, let's say you have $15,000 to invest. You set out to purchase 100 shares of stock XYZ at $15 per share. Without margin trading, you would be required to deposit $15,000 in your account. Using margins, you would essentially borrow $7,500 and only be required to deposit $7,500. A year later, if you sold the shares for $17.50 per share, you would have earned the following profit (does not include transaction or borrowing costs):
When you sold the shares, you would pay off the loan. Meanwhile, under the margin scenario, you could have invested the remaining $7,500 of the original $15,000 in other stock to diversify your position. The high risk of margin trading results from the fact that the value of securities fluctuates and if your securities lose value, so does the collateral backing your loan. If your equity level dips below a certain point--generally 30% of the market value of your securities--you'll receive a margin call to bring your account to the pre-determined minimum. A margin call requires you to add collateral or cash to your account, or sell some of your securities within a certain number of days. Don't be offended if you receive a margin call; securities firms are required to make a call to remain within regulatory guidelines. So, if you're using margin, you may want to retain a ready reserve of easily accessible cash (e.g., in a savings or checking account) so you can promptly meet a margin call. Additional margin trading information can be found at:
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Margin Trading
