While it is likely that you have heard of (and perhaps become familiar with) trading, you might not be as familiar with different types of trading practices. For example, the concept of margin trading. The term “margin trading” is used to describe the practice of using borrowed funds from a broker in order to trade a financial asset. Further, the financial asset being traded serves as collateral for the loan from the broker. Keep in mind, using financial leverage opens the possibility of magnified gains, however, it can also lead to disastrous losses. Consequently, investing with leverage has garnered a reputation as being a double-edged sword.
Since margin trading is associated with more risk than standard investing, it can only be accomplished using a specific type of account called a margin account — separate from an investor’s usual cash account. Further, while stocks can be purchased in both types of accounts, short transactions can only occur in margin accounts. Similarly, there are other instruments that can only be traded in margin accounts such as futures and commodities.
The word margin is used to describe the amount of money that an investor (or trader) must personally put forward from their own resources — this can differ significantly depending on the instrument or asset. For example, when an investor decides to utilize currency futures, they generally need to put forth a margin that amounts to a low single-digit percentage of the currency contract’s value. In contrast, a stock that is bought on margin tends to require that the investor puts up 30% – 50% of the value of the total transaction. By and large, the greater the volatility of the stock being purchased, the higher the margin requirement will be.
As mentioned above, buying shares on margin can provide some great advantages such as the ability to leverage your gains and buy more shares than you could if you were doing so only using the cash you have on hand. That said, trading on margin can also amplify losses so extreme caution should be considered. For instance, if the stocks purchased on margin have a (sudden) sharp decline, the investor will be accountable for a “margin call” and may have to produce a considerable amount of cash or marginable stock at short notice. Moreover, if the investor is not able to meet the margin call they are faced with, the brokerage will sell the margined securities without further notice (forced liquidation). In cases where the market is tanking, this forced liquidation could mean that an investor’s position is sold at a terrible time and a substantial loss is realized. Worse yet, if the plummeted margined stocks were to turn around and end up in the black, the investor would have taken a big loss in the short term when they could have made money in the long term if they had taken a traditional cash account position.
Clearly, margin trading can be complicated and requires special attention paid to due diligence. Therefore, it is probably most fitting for advanced traders or high-net worth investors who are aware and accepting of the associated risks. Likewise, a more average investor might want to consider long-term investments using cash accounts — which tend to expose them to less short term risk. Ultimately, though, it is up to each investor to make the decisions with their money that are best for them and that they are the most comfortable with!