Investing can seem like a foreign language sometimes. There are a whole bunch of acronyms and a lot of lingo to learn, even if you’ve been at it a while.
There are IRAs, 401Ks, 403Bs, stocks, bonds, common stock, index funds, exchange-traded funds, REITs, and a whole lot more. And that doesn’t even get into all the ways you can invest, like limit orders, stop orders, short sales, and fractional shares.
Then there’s margin trading, which can be a confusing trading method because it comes with a lot of rules—and a lot of specialized words and lingo. Maybe you’ve heard of it, maybe the term is wholly new, or maybe you’re thinking about getting into margin trading yourself.
No matter where you sit on the spectrum, margin trading is happening at record levels thanks to the bull market we’ve been enjoying in the United States.
In May of 2018, borrowing by margin traders hit an all-time high of $668.9 billion . That figure is over $100 billion higher than 2016 figures and over double of trading at the end of 2010 . That’s a whole lot of investors taking advantage of this unique way to invest in the stock market.
So margin trading is kind of a big deal, but what is it actually? How is it different than the way you might be buying stocks, ETFs, index funds, and other investments now? What are the potential benefits? What might some of the risks associated with margin trading be? And how do you get started?
At first, margin trading might seem a little bit more complicated than some other ways to invest in the stock market but, as the 2018 numbers can attest, it’s a method favored by a lot of folks.
How Does Margin Stock Trading Work?
There are different ways to buy stocks, funds, bonds, and other securities. You might buy one share of a company at its full price. You might buy a fractional share.
You might throw $10 a week into an ETF that’s made up of stocks from an industry you like or eco-friendly businesses.
Margin trading is a little bit different than these approaches. Trades are made using some of your money and someone else’s, usually a brokerage firm’s .
The investor takes out a loan on an investment they hope is going to rise, with the aim of seeing a return. When the investment is sold, the borrowed funds are returned, and the investor keeps the profits.
For example, if an investor wants to buy $5,000 worth of stock in something with a potentially big year, they could use $2,500 of their own money. The brokerage firm may lend the investor $2,500 to make up the difference so the total investment would be $5,000 for an initial cost of only $2,500 to the investor.
You’ll likely need a margin account with a brokerage firm to execute this kind of trade. The firm may require a minimum deposit in a margin account, and the account balance acts as collateral against the loan.
The loan often includes an interest rate, and the person borrowing the money for the margin trade is responsible for the amount owed plus interest. This means if the stock drops in value, the investor would still be responsible for the $2,500 and any interest on the loaned amount.
On the flip side, if the stock goes up, using a margin account effectively increases an investor’s purchasing power and potential profit. Margin exposes the investor to potentially greater gains or losses and is a riskier way to invest than not using margin.
Those are the basics, but there’s still a lot to learn before placing your first margin trade—like all the margin trade lingo, for instance.
Useful Margin Trading Terms
Because margin trading is a little different than some other ways to invest, it might be helpful to familiarize yourself with a few terms. Here are some key words you might run into.
This is the kind of brokerage account you’ll likely need to begin margin trading. It means the brokerage firm will lend funds for stock purchases.
The Financial Industry Regulatory Authority is a nonprofit organized by Congress. The organization oversees margin trading by writing and enforcing rules governing the industry, ensuring brokerage firms’ compliance with those rules, and educating investors. FINRA’s goal is to help protect investors and regulate brokerages to ensure they’re working in the best interests of American investors.
FINRA rules set a dollar amount that must be deposited based on the kind of margin trading to be executed. The amount may vary depending on the purchase amount of the investment and brokerage firm policies.
The initial margin for new accounts is set at 50% by Regulation T of the Federal Reserve Board . This means that a $10,000 trade, for example, would require an initial margin of $5,000. Some brokerages might even ask for more than 50% as part of the initial margin.
The maintenance margin specifies the amount of money that investors are required to keep in their margin accounts. According to the SEC, “FINRA rules require this ‘maintenance requirement’ to be at least 25 percent of the total market value of the securities purchased on margin (that is, ‘margin securities’).” This might mean investors may have to add cash to their margin accounts if the price of their investment drops significantly.
A margin call happens when the value of an investor’s margin account dips below the brokerage’s maintenance margin. The “call” is a request for the investor to meet the maintenance margin and usually happens when a security the investor purchased decreases in value.
Once you’ve familiarized yourself with margin trading lingo and some basic stock market terms, it might be helpful to understand some of the potential benefits and risks of margin trading.
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Potential Benefits of Margin Trading
A primary benefit of margin trading is the potential expansion of an investor’s purchasing power, sometimes exponentially. This could possibly help boost returns if the price of the stock or other investment purchased with a margin trade goes up.
Benefits of margin loans might include lower interest rates than other types of loans, such as personal loans, and the lack of a set repayment schedule.
You could also use margin trading to diversify your portfolio.
Another potential advantage might be a complicated trading method called short selling. Margin trading might make it possible for you to sell stocks short.
Short selling differs from most other investment strategies in that investors make a bet that a stock’s price will fall.
The rules for short selling with a margin account can get even more complicated than a traditional margin trade. For instance, Regulation T of the Federal Reserve Board requires margin accounts to have 150% of the value of the short sale when the trade is initiated.
While the benefits of being able to buy more investments—and potentially make more money—might seem appealing to some investors, there are some potential risks to margin investing that might be worth considering before you decide if it’s right for you.
Potentially Risky Business
While a primary benefit of margin trading may be increased buying power, investors could lose more money than they initially invested. Unlike a cash account, the traditional way to buy stocks or other investments, losses in a margin account can actually extend beyond the initial investment.
If an investor purchases $100 worth of stock with a cash account, the most they can lose is $100. If that same investor uses $100 of their own money and a margin—essentially a loan—of $400 and the stock loses value, they may actually end up owing more money than their initial $100.
Another potential negative aspect of margin trading is getting a margin call. Investors might have to put additional funds into their account on short notice if a margin call is triggered because the investment lost value. Additionally, a drop in value might mean an investor has to sell off some or all of the investment, likely at an inopportune time.
The SEC warns investors that if some of their stock must be sold to cover a margin call, the investor usually does not get to decide which investments are sold, and they may get little to no notice that their securities are going to be sold to cover a margin call. They also advise investors to be aware that a brokerage might increase margin requirements with little notice, also likely at an inopportune time.
How To Get Started With Margin Trading
Typically, the first step to getting started with margin trading is to open a margin trading account with a brokerage firm.
Even if you already have a stock or investment account, which are cash accounts, you still have to open a margin account because they are regulated differently. First-time margin investors have to deposit at least $2,000 per FINRA rules . If you’re looking to day trade, this dollar figure goes up to $25,000 according to FINRA rules. This is the minimum margin when opening a margin trading account.
FINRA defines a day trade as “the purchase and sale, or the sale and purchase, of the same security on the same day in a margin account.” These higher dollar amounts might be associated with what some have called the greater risk of day trading.
Once the margin account has been opened and the minimum margin supplied, the SEC advises investors to read the terms of their margin and have a grasp of how their new margin trading account will work.
The SEC advises investors to protect themselves by doing the following: “Understanding that your broker charges you interest for borrowing money and how that will affect the total return on your investments, being aware that not all securities can be purchased on margin, and knowing how a margin account works and what happens if the price of the securities purchased on margin declines.”
Does Margin Trading Work for Your Goals?
That’s the question most investors will probably have to answer for themselves once they’ve learned the lingo, weighed the pros and cons, and figured out how margin trading works.
As with most investing strategies and vehicles, margin trading comes with a unique set of potential benefits, risks, and rewards.
Margin trading can seem a little more complicated than some other approaches to investing, and it should be up to an individual investor to decide if the potential risks are worth the potential rewards and if this strategy aligns with their goals for the future.
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