Margin trading is a strategy traders use in various markets, including stocks, forex, and cryptocurrencies. It’s a high-risk trading method that requires traders to put cash in a brokerage firm as collateral for a loan and repay the borrowed funds with interest.
The leverage will almost certainly compound both profits and losses. In the event of a loss, a margin call may force your broker to liquidate shares without notification. Because of its ability to extend trade outcomes, margin trading is very popular in low-volatility markets like the international Forex market.
The majority of traders are always confused as to how this trading system works and how they may get started. This article will not only define margin trading but also explain how it works, the benefits, as well as the risks involved.
What is Margin?
Simply put, the margin is the amount of money that an investor or trader must deposit with their brokerage firm or exchange to cover the credit risk that the holder provides to the broker or exchange.
When you trade on margin, you borrow money from your broker to buy more products than you could with your own money. The product (stock, currency, etc) you buy will serve as collateral for the loan. Margin trading in cryptocurrency entails borrowing funds from a cryptocurrency exchange and utilizing them to execute a transaction. If you’re trading forex or stocks, then you’ll need to borrow money from a broker.
Margin trading is also known as trading with leverage because traders also have the ability “leverage up” their trades beyond the existing capital they have to work with.
In the financial markets, the term “margin trading” refers to when a single trader purchases extra stocks than they can afford. Whenever an investor buys an asset on margin, he or she borrows the remaining funds from a broker. The first payment that is made to the broker for the asset is referred to as buying on margin, and the investor utilizes the marginal securities in their brokerage account as collateral.
How does margin trading work?
A trader will be forced to commit a proportion of the total order amount when initiating a margin trade. The margin is a term that refers to the original investment and is strongly tied to the concept of leverage. To put it another way, margin trading accounts are used to produce leveraged trading, and leverage refers to the amount of borrowed funds compared to the margin.
For instance, a trader would need to contribute $1,000 of their capital to the exchange or broker, as the case may be, to open a $10,000 deal at a leverage of 10:1.
It can also be used while trading or investing in stocks. For example, suppose an investor wishes to buy 300 shares of a corporation trading at $20 per share but only has $3,000 in his trading account. He makes the decision to use the cash to buy half (150 shares) and borrow $3,000 from his brokerage company to acquire the other 100 shares on margin, for a net initial investment of $6,000.
Let’s imagine the stock price goes up to $30, that means her initial $6,000 investment is now worth around $9,000. Despite the fact that the trader must repay the borrowed funds, he is entitled to the profits he made as a result of their assistance. The trader in this example ends up with $6,000 after returning the $3,000. Her gains would have been around $2,000 if she had merely invested her $3,000 in cash.
Major Margin Trading Terms
When it comes to margin trading, there are a few crucial terms to know. The following are some of them:
A margin call acts as a reminder that your margin account needs to be restored to good standing. You may need to deposit cash or fresh securities into your account, or you may need to refinance your loan to enhance your asset-to-loan ratio, or you may need to sell existing securities.
If your trading position goes against you and your present capital is insufficient to fulfill your margin obligation, your broker or exchange, as the case may be, will issue you a margin call.
The initial margin, also known as the deposit margin, is the least amount of money you must deposit to initiate a trading position. Investors can borrow up to 50% of the original purchase price of stocks under the Federal Reserve’s Regulation T, while some brokers require a greater initial margin.
The amount of account equity required to prevent a margin call is known as the maintenance margin. When you buy stocks on margin, you must keep a certain percentage of your own money in your margin account. The minimum maintenance need is 25%, however, depending on the broker, it can be as high as 40%. This regulation ensures that investors stay in the space and do not become excessively indebted.
Pros of Margin Trading
- Margin trading offers a greater chance of making huge profits in a short period of time.
- Margin trading can be used to make winning bets during smaller market movements across all financial markets. That is why it is ideal for traders who want to profit from price swings in the near term but don’t have enough cash on hand.
- Margin trading is restricted to a few providers, thus market regulators and stock exchanges keep a close eye on the margin trade facilities.
Cons of Margin Trading
- Losses can be magnified by the margin, and you may lose more than you invested. Traders have the potential to lose a lot of money quickly. They may be entirely liquidated at a loss during periods of high volatility if proper care is not taken.
- Margin trading, in contrast to typical spot trading, poses the danger of losing over their initial investment to traders, making it a very high-risk trading system to follow.\
- Borrowing money in a traditional way isn’t free, either. When you utilise margin to invest, you must pay interest on the amount borrowed. It differs from broker to broker because each can establish its own price.
It should be mentioned that margin trading is better suited for highly skilled traders who may need access to multiple funds to execute a complex trading strategy. Less experienced traders are expected to avoid margin due to the numerous risks involved with the trading mechanism, albeit using a very little amount that you can easily repay can reduce the risks of using it.