Executive summary: I do not believe it is wise to trade on margin. You could lose everything when you margin trade if the stock or the stock market turns on you, as it did very quickly in March 2020. It is better to invest in low-cost index funds or ETFs and buy and hold for the long term.
Margin trading has gained popularity in recent years, but many investors are remaining cautious. The NYSE reported record levels of margin debt, reaching close to $505 billion in June. Since then, the levels have dropped down to $487 billion in July and $473 billion in March 2019. In 2021, the margin trading amount is probably even more.
Although many perceive it as risky, margin trading has several benefits and conveniences if used responsibly.
Let’s examine the process behind margin trading. We’ll cover several ways to manage the risks to help you reap the benefits.
Margin Trade Minimums And Restrictions
Trading on margin simply means taking out a loan with a broker dealer that can be used to place trades. Margin accounts are typically maintained separately from traditional cash accounts.
Margin loan terms are based on federal regulations and broker specific conditions. Currently, the maximum amount investors can borrow is 50 percent of a purchase per federal regulations. For example, if you want to buy $10,000 of stock, only $5,000 can be funded by a margin loan.
Typically, the minimum margin deposit brokerage firms require is $2,000. Brokers also have maintenance margin restrictions, which are minimum balances that must be maintained through margin calls. If the value of a security drops below this level, the investor would be required to sell shares or deposit additional cash.
Keep in mind sale proceeds are collected by the broker first and go towards repayment of margins loan before you get to pocket any profits.
Manage Margin Risk Carefully
Here’s a look at several ways to help manage the risks of margin trading.
Don’t invest what you can’t afford to lose. Trading on margin comes with the risk of amplified losses. Let’s say you borrow $1,000 to buy $2,000 of a stock.
If the stock goes down 50% and there’s a margin call, you will have essentially lost 100% of your investment. Add in the cost of interest charges and you could actually lose more money than you put in.
Consider setting a stop-loss order to protect your initial capital if you trade with leverage.
Borrow less than the maximum limits. Simply having access to leverage doesn’t necessarily mean every investor should take on the added risk. Test your skills slowly and in small amounts.
Watch out for extra sensitivity. Margin accounts are more sensitive to day-to-day market movements than cash accounts.
Always Do Your Due Diligence Before Buying Stocks Or Any Risk Assets
Research stocks carefully. Don’t use margin to buy stocks in which you haven’t thoroughly analyzed and lack confidence. You can use a method like the SAMURAI test to really study a stock before you margin trade.
If you own a declining stock in a cash account, you have the option to hold in hopes of a rebound. However, in a margin account, if a stock’s price drops too much, you could be forced to sell and miss out on a potential recovery.
Borrow just for the short-term to minimize costs. Margin account holders are charged monthly interest fees for borrowing money, just like a car loan or mortgage. Generally, the more and longer you borrow, the more expensive it gets. Compounding interest fees can make it difficult to turn a profit if margin investments are held long-term.
Plan ahead for margin calls. Don’t let margin calls catch you by surprise and force you to liquidate prematurely. Put an unwavering plan in place for funding margin calls and stick with it.
Monitor your accounts attentively and maintain a well-diversified portfolio. Keep a close eye on your holdings with a free platform like Personal Capital. And avoid putting all of your eggs in one basket.
Four Benefits Of Margin Trading
Now that you’ve learned several ways to manage the risks of margin trading, here are some of the potential benefits to get excited about.
1. Multipurpose Line Of Credit – A lesser-known advantage of getting approved for a margin account is that you can borrow against your assets for non-trading purposes. If you are in need of funds for personal use, you can take out a loan using your margin account without the hassle of credit checks or additional paperwork.
2. Low-Cost Interest Rates – The interest rates in a margin account can also be cheaper than other lending options such as credit cards and home equity lines of credit. There are also no minimum monthly payments required beyond margin call requirements. Access to the debt is much easier as well.
3. Added Purchasing Power – By trading on margin, investors can purchase more shares than the value of the available cash in their accounts. Margin accounts can be used for buying long as well as selling short. If well executed, the increased market exposure margin trading provides can result in higher returns.
4. Flexibility And Diversity – If you’re short on cash temporarily and a trading opportunity arises, trading on margin can help you avoid selling your existing securities prematurely just to raise cash. Margin accounts can also provide the opportunity to diversify a concentrated portfolio.
Margin Trading Solution
Evaluate your risk tolerance, investment strategies and costs carefully before trading on margin. When used responsibly, margin accounts can provide multiple benefits to investors. Just know that if you are leveraged 100%, if your position goes down 50%, you lose everything.
Leverage is great on the way up, as we've seen in the various coastal city housing markets over the years. But leverage can destroy your investments on the way down. I wouldn't go on margin with any money you cannot afford to lose.
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