One of the most profitable – and riskiest – ways to trade stocks is to trade on margin. If you haven’t heard of this method before, it’s probably because trading on margin carries with it a lot of risk to go along with the upside potential. I’ll cover the basics of this trading method and give you a good perspective on the risks versus potential reward.
What is Trading on Margin?
Normally, when you buy and sell stocks, you are doing so only with the amount of money you have actually in your account. This is your capital. Buying is constricted by the amount of liquid capital (cash, essentially) you have in your account. For example, if you have $10,000 in your account, and you want to pick up Exxon Mobil (XOM) at $82 per share, you can only buy 121 shares.
If the stock appreciates by, say, 1% – or 0.82 – you gain a profit of $99.22. In this way, the amount of money you can earn is limited by a one-to-one ratio. Your buying power is $10,000; the only way to increase that in a cash account is to either deposit more money or gain money by selling shares for a profit.
Trading on margin gives you the ability to increase your buying power without actually increasing the amount of money you have in your cash account. In other words, you are leveraging your buying power and using your capital to buy way more stock than you normally would be able to. This is accomplished by borrowing money from your broker.
How to Trade on Margin
To trade on margin, you have to open an account that allows you to do so, called a margin account. This means you’ll have to obtain approval from your brokerage and deposit what is called the minimum margin, or the initial investment you’ll have to have. You’ll have to put in at least $2,000, although that number may increase depending on what service you use.
Then, you will have to have what is called initial margin – which is the amount you’d have to supply for your share of the stock’s purchase price. Most brokers allow you to borrow up to 50% of the purchase price, although you can choose to use smaller amounts.
Once your margin account has been approved and you have the required minimum margin and initial margin, you can trade as normal.
The Power of Marginand Leverage
Margin stock trading gives you a powerful capability to make more money with what assets you have.
For example, let’s say you still have $10,000 in your account. You want more than 121 shares. If your broker allows 50% margin – i.e. you pay half of what it costs to purchase these shares and you borrow the rest – that means you can effectively double your investment and obtain twice as many shares.
The total amount you want is 242 shares. That would normally cost $19,844 at $82 per share. But, since you have a margin account, you can borrow up to 50% of that amount, or $9,982. If the stock goes up by 1% to $82.82, you would gain $198.44 in profit.
Under this scenario, you would effectively double your return from your original investment if you only used the original $10,000. You can probably see the benefits and why someone would want to trade on margin – especially if you start off with a low amount of capital and want to quickly grow it so you can earn a living as a trader.
But, as with anything related to the stock market, there are risks.
Risk Versus Reward
Margin trading is, hands down, the fastest way to make money on the market (short of being Mark Zuckerberg and leading Facebook to its IPO). But, it is also the riskiest because it puts at risk money you don’t really have – but you are accountable for.
Let’s assume that you make the above margin trade, but instead of going up by 1%, the stock drops by 1%, down to 81.18 (a loss of 82 cents per share). Multiply that 0.82 times 242 shares instead of 121 and you are stuck with a loss of $198.44. Before, if you traded with the initial $10,000, you’d only be down $99.22.
It gets worse. Since you are borrowing that money, interest is being charged by the brokerage. So, you have to factor in interest payments if you hold the stock for any long period of time. Additionally, you face the specter of one of the most dreaded terms in the stock trading business: the margin call.
A margin call is a notice from your brokerage that you have exceeded something called the minimum margin requirement (MMR). This amount is the minimum amount of capital you need in your margin account at all times, in order to be able to pay off your loan. If the minimum margin requirement is, say, 25%, you have to maintain 25% of the total value of your stock in your account. If you bought $20,000 worth of stock, that would work out to $5,000 in your account at all times.
You can actually use a formula to determine the stock price that would trigger a margin call:
(Current Market Value of the Stock – Amount Borrowed) / Current Market Value = Minimum Margin Requirement
Current Market Value is the price times the number of shares. You own 242 shares, so that would equal 242P. You’ve borrowed roughly $10,000, and your MMR is 25%. The equation would look like this:
(242P – 10,000) / 242P = 0.25
Solving for P would give you $55.10. In other words, you will get a margin call if the stock price drops to $55.10. You would then have to either deposit additional funds or sell off your stock to meet the requirement.
Is Trading on Margin Right For You?
The answer to this question depends on your risk tolerance. If you’re an aggressive trader, trading on margin could benefit you. If you are conservative and would rather grow your portfolio gradually, margin trading probably isn’t the best idea.
Understand how much you are willing to risk, and never trade on margin with critical funds that you could need for emergencies. Some of the worst disaster stories from individual traders come from people who blew through savings funds by day-trading on margin.
If you understand the risks and are ready to accept them in exchange for the potential for bigger, faster returns, margin trading may be your best bet.