The Promise and Pitfalls of Margin Trading

Margin trading can be an effective, albeit high-risk, strategy to potentially boost profits from a variety of securities. Simply put, margin trading enables you to use borrowed money to buy more securities than if you only used cash.

But margin trading comes with big risks every trader should consider. While you could boost your gains, margin can also multiply your losses exponentially. Buying on margin also means you’re taking on debt, which, along with interest, eventually must be repaid.

In addition, you could be subject to a margin call, which happens when your maintenance level – or the percentage of equity in a security – falls below a certain threshold. In that case you might be required to sell shares to return your debt ratio back to acceptable levels.

Depending on how far a security declines, you could face a loss that exceeds your ability to pay it off.

For example, say you buy 1,000 shares of XYZ at $10 per share. When you trade on margin, you’re usually required to make an initial investment equal to half (50%) of the purchase. Your brokerage lends you the other half. The total cost would be $10,000 – your initial investment of $5,000 plus you borrowing the other $5,000.

If you sell your shares of XYZ at $12 a share, the total proceeds would equal $12,000. You must pay back your margin loan ($5,000), which leaves you with $7,000. Since your initial investment was $5,000, you would net a 40% gain. Compare with the scenario if you had used $5,000 cash to make your initial purchase. You would then have been able to buy half the number of shares (500 shares at $10 each). If the stock rose to $12 per share and you sold your 500 shares, you would have profited $1,000 – or a gain of 20%.

Starting Point

To use margin, you have to be approved for and then establish a margin account. Once the account is created, you’re allowed to borrow up to 50% of the purchase price of a stock. (This requirement is set by the Federal Reserve Board and is subject to change.) There are a couple of ways you might use margin as part of your trading plan.

Acquiring More Shares

With margin, you can effectively double your purchasing power. If you have $5,000 in cash, you can acquire $10,000 in a security. In that case, your returns also are amplified. A 5% increase effectively returns 10% to you, minus your interest costs.

But margin can amplify losses, too. A 5% decline in the security’s price equals a 10% loss to you. And if a stock continues to fall, not only would your losses double, but you could be subject to a margin call.

Plus, even if your security does not increase or decrease in value but stays flat, you still have the interest on the margin loan you have to pay.

Shorting Securities

When you go long on an investment, you are buying a security believing it will increase in value. Conversely, when you go short, you are expecting to profit from a drop in the share price. A margin account allows you to sell short securities so that you can profit from this decrease. One significant risk in considering short sales is that your risk is much greater than going long. If you go long and a stock falls, it cannot fall below zero. With a short position, however, your loss is potentially limitless because a stock can continue rising.

“That’s why it’s a good idea to monitor all of your margin positions regularly,” said Brian Bachelier, vice president of active trader strategy for Scottrade.

Margin Interest

Margin loans can be more cost-effective than other lending options, such as credit cards, by offering competitive interest rates. Repayment is flexible, and, in some instances, interest on a margin loan can be tax deductible. You should consult a tax professional.

“It’s important that you use margin responsibly and understand whether it fits your overall trading plan,” Bachelier said. “As with every part of a successful trading strategy, planning helps you avoid trading outside of your comfort zone. Developing an overall plan and sticking to it helps you manage risk.”

Next:  Check out “4 Tips for Managing Margin Risk” and “Primary Margin Risks.”

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