How Margin Trading Works
When you trade on margin, you pay a portion of the cost required to buy securities and Scottrade loans you the remaining amount. An interest charge is applied to your account monthly based on the amount of funds you borrow.
Based on federal regulations, you may borrow up to 50% of the total cost of a purchase. Because margin allows you to leverage your assets, your gains and losses can be amplified. Let's take a look at how this works:
For both examples below, assume that you deposit $15,000 into a margin account. As a result, your buying power would now be $30,000 (your $15,000 deposit + $15,000 from Scottrade). You purchase 1,000 shares of a marginable stock at $30 per share, which totals $30,000.
Example One – Market Value Increases
With Margin Loan: If the value of the stock rises to $40 per share and you sell your 1,000 shares, the total proceeds would equal $40,000. You repay the $15,000 you borrowed and then keep the $25,000. Since you initially invested $15,000, your net gain is $10,000 (minus interest and commissions).
Without Margin Loan: If you had used only your original $15,000 deposit, you would have been able to purchase half the amount of shares – 500 – at the $30 per share price. If you sold the stock when the share price rose to $40, your proceeds would have equaled $20,000. Since your original investment was $15,000, your net gain would have only been $5,000 (minus commissions).
Example Two – Market Value Decreases
With Margin Loan: Using the same initial scenario, let's say the stock price dropped to $20 per share and you decided to sell. In that case, the total proceeds from the sale would equal $20,000. You would still have to repay your original loan amount of $15,000, leaving you with $5,000. Since you started with an initial investment of $15,000, your net loss would be $10,000 (plus interest and commissions).
Without Margin Loan: If you had used only your original $15,000 deposit, you would have been able to purchase half the amount of shares – 500 – at the $30 share price. If you had sold your stock when the share price dropped to $20 per share, the sale proceeds would have equaled $10,000. Since you started with a $15,000 investment, your net loss would have only been $5,000 (plus commissions).
While trading on margin can potentially do as much as double your gain, there is substantial risk associated with margin because your losses can also double. It's important to realize that you can lose more money than you deposit in a margin account. When that happens, you will still be responsible for repaying your margin loan with interest.
Effective margin trading requires you to use margin responsibly and make sure you're aware of your risk tolerance when determining how margin fits into your trading strategy. Read 4 Tips for Managing Margin Risk to learn about ways you can address margin risk in your portfolio.