Margin trading is the process by which individual traders in a stock market can purchase greater shares and capital and make more investment than their current funds will allow.
A brokerage firm or an investment broker provides the capital necessary for such a trade to occur. In simple terms, it is the act of trading in the market using a third party’s loan, much like how we take out loans from a bank to finance our investments.
Margin trading provides a crucial opportunity for traders to access larger amounts of capital to make better use of their unique trade positions.
It can open up the doors to massive profits if utilized properly in a non-volatile market with proper risk-management strategies. However, it can also put you at risk of incurring double the losses.
Traders are usually required to speculate the value of assets and shares and trade them in a single session.
Newer firms, however, have significantly relaxed this requirement, and the advent of electronic stock exchanges has made this trading technique accessible to a larger number of people.
Important: It’s always a good idea to learn the technical parts of stock investing like learning how to read candlesticks chart, days the market is open, different patterns, and more.
How Margin Trading Works
1. Minimum Margin
Margin trading works in much the same way as a normal loan does. You are required to pay back the funds loaned out to you with an agreed-upon interest regardless of whether you make a profit or suffer a loss.
Before traders can move forward with a margin trade, they must deposit a certain percentage of the total order value to the broker.
This acts as a form of confidence for brokers to lend and an extra way for them to recuperate their losses in the event of a rainy day. This deposit is also called a minimum margin.
2. Leveraged Trading
This minimum margin opens the doors to leveraged trading. It means for every dollar you deposit to a broker; you have access to funds at a certain ratio compared to your initial deposit. The leverage ratio depends on the market you are trading in, with Forex markets offering ratios of 50:1 or even 200:1 while standard markets typically offer a 2:1 ratio.
For example, if you deposit $1000 in a market with a 2:1 deposit ratio, you will get loaned out double that initial deposit, which in this case is $2000. You can see that the loaned-out value increases with some leverage ratios, and it can open up the possibility for you to enjoy a more dominant trade position as you have more funds to trade and invest with. This is why margin trading is so appealing to experienced traders.
3. The Margin Call
However, not all is smooth sailing. In the event of the market moving against you by a significant margin, you stand to incur double the losses. You will be asked to deposit more funds to maintain the minimum trade margin if the equities in your margin account fall below that margin.
If you cannot deposit that amount, your minimum margin is taken by the broker to square off the debt. If that amount is not enough to repay the loan, then they can force you to liquidate your assets and sell all your investment capital at a loss. Such a move is called a margin call and is something all traders must be especially careful of.
Advantages of Margin Trading
With the process out of the way, let’s talk about the benefits of such a technique.
1. Greater Profits
The most obvious benefit is that you can enjoy much larger profits than you normally would due to the trade position afforded to you.
For example, if you invest $20000 and receive a return of $5000 on that amount, you can gain much larger profits because the return also acts on the money loaned out to you by the broker.
If the loan amount was $40000, you stand to gain an extra $10000 just by engaging in margin trading.
This return scales up the higher the investment sums and can open up substantial profits for you to jumpstart your business or make more lucrative trades.
2. Trade Diversification
Another substantial benefit of margin trading is that it allows you to trade with multiple different firms and corners of the market.
When previously, limited funds would have prevented you from high-volume trading, this method can allow you to open up investment opportunities and trade connections with a small initial deposit.
For many traders looking to diversify their portfolios or create a wider base of trading assets that can help recuperate their losses, this is a massive boon.
3. Flexibility to Market Changes
The final underrated benefit that no one seems to talk about is that margin trading allows you to respond quickly to surges in share prices.
Normally, it would be difficult for an individual trader to buy up shares in a company that is experiencing rapid growth if they had already pledged their funds to another firm.
This trading technique allows them to buy shares in that booming company regardless because the initial investment that the trader needs to cough up is substantially low. This allows them to quickly shift their investment strategies on the fly and get ahead of the competition.
Disadvantages of Margin Trading
The most obvious disadvantage comes in the form of increased losses if you make a bad decision. Even a small drop in share prices or a small shift of the market against you can incur substantial losses. On top of that, you need to pay back the broker the full amount of the loan with increased interest.
If you are unable to do so, your assets will be liquidated, and you may find yourself without any capital to continue trading. In the most extreme cases, the loan is not repaid even after liquidation.
This is a nightmarish situation to be in as you have to cough up even more money to pay back your debts. For these reasons, margin trading is considered a high-risk trading method.
To extract the maximum benefit from margin trading, one must trade in relatively low volatile markets where there is a positive trend of share prices increasing and a relatively lower likelihood of drastic market shifts.
It is also crucial to employ proper risk-management strategies. When used effectively, margin trading is a wonderful tool in your arsenal.