Trading on margin offers traders the opportunity to amplify their returns using borrowed money. However, investors should understand that trading on margin operates like a double-edged sword; while it allows you to multiply your gains, it can also multiply your losses.
At its core, margin trading involves borrowing from your broker to increase your purchasing power. This allows you to buy well beyond the actual cash you have at your disposal. We’ll cover the mechanics of how this works, as well as the risks and benefits of undertaking such a strategy.
Understanding Margin Trading
Margin trading means borrowing funds from your broker and using those funds to buy securities. Any borrowed funds must be repaid, with interest, regardless of whether or not you earn a profit on your trade. If you’re wondering about the difference between leverage vs. margin, basically margin is a form of leverage.
When trading on margin, your broker will require you to post cash collateral to match a percentage of the funds you borrowed. This is known as the margin, and the exact amount is set by your broker, the type of security traded, and prevailing market conditions.
Risks and Benefits of Margin Trading
We spell out some of the most obvious risks and benefits to margin trading below.
|Amplified losses||Enhanced returns|
|High interest expense||Added liquidity|
|Risk of margin call||No set repayment schedule|
Benefits of Margin Trading
Enhanced returns: The main benefit to margin trading is its ability to magnify your exposure to trades. This offers the potential for greater earnings thanks to the additional shares you accumulate (as well as the potential for loss).
Added liquidity: Assuming you remain inside of acceptable maintenance margin requirements, margin trading grants additional buying power to smaller cash balances, which can be useful if you don’t want to liquidate existing holdings.
No set repayment schedule: Unlike standard fixed loans, there’s no repayment schedule for repaying your margin loan. The interest accrues while your balance remains outstanding, and is only repaid once the position is closed.
Risks of Margin Trading
Amplified losses: Due to the larger position size afforded through margin trading, your losses will also be greater in the event the market moves against you.
High interest expense: Interest rates on margin loans can range from low single digits to as high as 11% or more, depending on your broker and the size of your margin balance. At best, this is a drag on investment returns; at worst, an additional cost you have to pay on a loss.
Risk of margin calls: If at any point, the value of your investments fall beneath a broker’s posted margin requirements, you will be required to deposit additional collateral to cover the shortfall. This is known as a margin call.
Failure to meet a margin call can result in a forced sale of your security, additional charges, and other penalties as dictated by your brokerage firm’s policies.
Increase your buying power with a margin loan from SoFi.
Borrow against your current investments at just 10%* and start margin trading.
Is Margin Trading Ever Not Risky?
Under no circumstances is margin trading ever considered free of risk. The core precept of all investing involves risk, and leveraged strategies like margin trading increase risk exposure.
Unlike cash accounts, which limit your losses to the value of your initial investment, margin accounts can result in losses that exceed the value of your initial deposit.
Is Margin Trading a Good Idea for You?
Margin trading isn’t for all investors, and its suitability depends on both the scenario as well as the experience and knowledge of each individual investor.
Trading on margin can be useful when you have a high conviction short-term trade idea and wish to overweight your exposure to that trade.
It can also provide the benefit of additional liquidity when much of your cash is tied up in existing investments that can’t be quickly unwound.
When considering margin trading, investors need to be willing and able to absorb any potential losses associated with this strategy. Make sure you fully understand the dynamics of each trade before opening a margin position.
Alternatives to Margin Trading
Given the high risk of loss associated with margin trading, it’s important for investors to explore other options. There are several alternatives to margin trading.
Keep in mind that under all scenarios cited, the magnified gain and loss dynamics still apply, and may or may not exceed the potential losses or gains a trader can obtain by trading on margin.
Penny stocks offer investors exposure to large swings in value, thanks to the low cost of each individual share. However, penny stocks are often cheap for a reason. Investors should conduct their own due diligence to understand the dynamics of any new holding they consider.
Cryptocurrencies are relative newcomers on the investment scene. The crypto space barely existed before Bitcoin launched in 2009.
Today, there are thousands of different crypto coins and tokens. These are high volatility investments that can change dramatically in value day to day.
The underlying technology is complex and can expose investors to the risk of total loss. Make sure you understand the risk reward dynamics of such a trade before buying any cryptocurrency.
Margin Trading With SoFi
If you’re looking to enhance your investment toolbox, SoFi offers margin loans through its trading app. Eligible members can obtain margin loans on their investments at a competitive annual interest rate.
What are the downsides of trading on margin?
Trading on margin involves a number of possible downsides, including added interest costs, heightened portfolio volatility, and magnified losses that may exceed the value of your initial investment.
Do some people make a lot of money trading on margin?
Trading on margin can amplify your potential investment returns thanks to the added buying power it offers. However, this multiplier effect swings both ways and will amplify the size of your loss, should the market move against you.
Is margin trading a good long-term investment strategy?
Margin trading is a form of leveraged trading and therefore not recommended for long-term investors. Over extended periods of time, there’s a heightened risk that market volatility may force a margin call.
The added interest expense incurred by margin loans can act as a drag on your investment returns. This introduces an additional cost that you must cover, should your investment fail to outperform the interest expense incurred on your margin loan.
Photo credit: iStock/valentinrussanov
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*Borrow at 10%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.