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While you could always try your luck at a casino, one of the best ways to turn some money into more money is the stock market or other market for financial instruments.
Investing is accessible to nearly everyone, and it has the dual purpose of helping regular people increase their net worth while also allowing companies to raise money for new projects to increase the company’s value.
The other side of the money-making coin, however, is risk. All investing involves some level of risk.
That doesn’t stop some people from increasing their leverage and boosting the profit from a successful investment.
You can increase your leverage using something called “margin.” Should you use margin, though? Let’s explain what it is first, then help you find out how to use it.
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What is Margin Trading?
Trading on margin means that you are using someone else’s – usually your broker’s – money to increase the leverage on a position or on your portfolio with the intent of increasing your profit potential on a successful trade.
If the trade is unsuccessful and goes against you, there is a chance you might receive the dreaded “margin call” from your broker. We’ll get to that later.
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Understanding Margin Trading
Let’s start by explaining how simple trading works to help illustrate margin trading. When you trade a single position with no margin or leverage, you are risking just the funds you have in your trading account on that position.
When you place a trade without any margin, the investable funds in your account will decrease by the position size.
This simply puts all the risk for that position on you and makes sure that you can’t over-leverage yourself by opening more positions than your funds can cover should everything go to zero.
When you trade with margin, you only have to risk a certain amount or percentage of the position size, depending on your broker.
The remainder is provided as margin by the broker. This is essentially a loan, and it might come with special fees or even interest, just like a loan would.
Trading on margin means that you can open bigger positions than you would if you only traded with your money.
Successful trades on margin will usually result in larger profits, but remember, it is risky and not recommended for beginner investors.
Example of Buying With Margin
It’s far easier to understand using an example. Let’s use Apple, currently trading at a nice round $500.
Further to this, let’s say that you have a $100,000 account and a maximum position size of $5,000.
If you are not trading on margin, you would simply buy $5,000 of Apple stock, equal to 10 shares.
Your investable funds would decrease by $5,000, so you now have only $95,000 left to put into other positions.
If Apple goes up to $600, then the value of that position would be $6,000, a profit of $1,000.
Let’s say your broker now offers 50% margin on stock trades. Using the same parameters as above, your investable funds would only decrease by $2,500.
You could also double the position size to 20 shares to keep a $5,000 position size. The total position size, including the broker’s margin, is now $10,000.
If Apple goes up to $600 now, the position would be worth $12,000 – a profit of $2,000.
You keep the $2,000 and give back the broker’s $2,500 (this is usually automatic when you close the position). Your account is now $102,000.
Stocks can’t always go up, though. If Apple were to fall to $400, the opposite would be true.
You’d have to give back the whole margin of $2,500 still since the broker takes no risk, but you’d be left with a $2,000 loss.
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Advantages of Using Margin
- Margin can improve profit potential
- Most well-known brokers will offer margin, so it’s easily accessible.
- Some brokers offer margin of at least 50% for free on accounts over a certain amount
Disadvantages of Using Margin
- While profit potential is improved, losses can also be greater for losing positions.
- Using margin opens up the possibility of receiving a margin call, which may require closing other positions or risk the position being automatically closed.
- Margin is sometimes treated like a loan at some brokers, and they will charge interest or other fees, which can take away from profits.
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What is a Margin Call?
Here, we get to a very complicated and potentially very stressful aspect of using margin. When you receive a margin call, it’s usually an email, text, alert from an app, or all of these.
You receive a margin call when the investable funds in your account have decreased beyond the maintenance level required to keep your positions open.
When a broker extends margin to you, the understanding is that you will keep the profit, but you also assume all of the risk.
This means that if one or several positions go against you, the maximum loss that the broker will allow only goes up to the required maintenance margin level
A margin call gives you notice that you have a certain amount of time to either close the position, deposit more money into your account, or close positions to fund the current positions.
What does it mean to trade on margin?
Trading on margin means that you are using someone else’s money to help fund a position or several positions.
This increases the profit potential as well as the loss potential on losing trades.
How much margin can I use?
That depends on your broker as well as the market you’re trading.
The Financial Industry Regulatory Authority (FINRA) requires an investor to put up at least 25% as a maintenance margin.
This means that the maximum margin allowed to be extended on equity (stock) margin accounts is 75%.
Most brokers require more than this, sometimes 30%, 40%, or 50%.
However, if you consider a market such as foreign currency, the margin is quite a bit higher.
The daily changes in foreign currency pairs are extraordinarily small. The unit of change is called a pip, and a single pip for most currency pairs is $0.0001.
To trade effectively, it’s not uncommon for regular forex traders to use 1% margin, only putting up $1,000 to control $100,000 worth of a given currency pair.
What are some other meanings of the term margin?
When talking about an equity account, margin will usually refer to borrowed money to help fund the account or position.
There is also something called portfolio margin, which is usually meant for larger accounts in derivatives (options or futures) accounts.
If a trader is placing positions that are both long and short, certain combinations could be deemed to cancel each other out to the extent that it reduces the amount of maintenance margin required for the account.
There are other uses of margin as well, such as accounting margin. Businesses maintain a predetermined requirement for a certain product to sell at a certain percentage price above the costs that went into producing it.
The difference between the sale price and the cost of production is known as margin.
How do I use margin?
Margin must be requested specifically from your broker. Most larger brokers have a relatively simple way of applying for a margin account, but it’s worth spending extra time to understand margin before assuming it’s a good idea for you.
There is also every possibility that a broker might deny your request based on whether you meet certain requirements.
Most of these requirements are posted on a broker’s website.
Bottom Line: What is Margin?
Margin trading is when you use your broker’s money in addition to your funds to open larger positions that can yield bigger profits. It can also lead to larger losses in losing positions.
Most brokers who offer margin only give it to those investors with accounts of a certain size, and even then, the margin offered might involve paying additional interest or fees.
Be sure to understand how your broker extends margin because each broker is a bit different.
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