This ultimately depends on your level of risk tolerance. Trading any instrument on margin involves borrowing additional funds to give you extra funds for trading.
What Is Margin Stock Trading?
Margin trading is where your stock broker lends you some funds so you have extra buying power with your account. When you sign up with a broker, they often ask if you would like a margin account or cash account. A margin account is where you have the option to borrow funds, a cash account is just a normal account without the option to borrow funds.
If you have a margin account, many brokers will lend you up to half the value of a stock. For example if you wanted to by $2,000 worth of stock, many brokers would lend you $1,000 for the purchase.
You do not have to borrow the full 50%, you could borrow any amount, for example 30% or 15%.
The amount you put up yourself for the stock purchase is known as the initial margin.
There is also maintenance margin to consider. This is the lowest your account size can be, before your broker needs more funds from you.
The Margin Call
If your account size becomes too low, your broker will give you a call telling you they need more margin (money) to keep your trade(s) open.
This is commonly called a “margin call”. They are often very unwelcome by traders. However, more margin must be supplied when requested by the brokeror you risk having them close your trades.
Many brokers have different terms and conditions regarding borrowing money and margin requirements, so be sure to speak to them in detail about your borrowing needs before hand.
It is strongly advisable to fully understand your brokers margin policy and fund your account appropriately so your broker never needs to make a margin call. If you are unsure about anything, give them a call or email their support.
Costs Of Borrowing
As with most kinds of borrowing, there are interest charges to pay on borrowed funds. Whilst there is no time limit placed on how long you can borrow money from a broker, long term loans can become very costly.
Interest charges are usually somewhat related to the central bank rate, though they can vary massively between brokers.
The securities in your account are usually used as collateral for borrowed funds. If a broker needs to close your trades, they will take all the fees they are due from your account.
If you would like to compare margin rates between the major brokers, I have done this for you and put the results on the discount stock brokers page of the site.
Example Of Margin Stock Trading
Let’s say I wanted to buy $10,000 worth of stock in Microsoft. I use $5,000 of my own money and borrow the other $5,000 from my broker.
If after a year the Microsoft stock had risen 20%, my $10,000 investment would have grown to $12,000. However, as I own put up $5,000, my return is doubled. In this scenario I would earn a $2,000 return on my $5,000 investment, this is 40%.
On the flip side, if the Microsoft stock had plummeted 15%, my $10,000 investment would have dropped to $8,500. A drop of $1,500.
As I only put up $5,000, this drop of $1,500 results in a significant loss on my $5,000 investment. The 15% loss is doubled to a 30% loss.
For simplicity this example does not factor in trading fees and interest charges.
So What Can We Learn?
- Borrowing money can substantially increase profits and losses.
- Borrowing money increases risk.
- Borrowing money can result in a margin call if your account dips too low.
- Borrowing money can be costly and eat into your returns or add to your losses.
- Initial margin is the amount of money needed to execute a trade.
- Maintenance margin is the amount of money you need in your account to keep a trade open.
My personal thoughts on margin
Personally I am not a fan of margin. I have always the view that if you know you are doing, you can do well without borrowing money and if you don’t know what you are doing, you certainly shouldn’t be using it!
Not everyone shares my view, but I have seen so many talented traders crash and burn because of using too much margin. Be careful.