Margin Trading: Definition, Working, Advantages and Risks

You must have missed a trading opportunity due to the lack of funds. What if there was a way to grab that opportunity even with the lack of funds? Yes, you read that right, it is possible with margin trading.

Margin Trading is the process where a trader borrows the money from the broker, to trade in the markets with an increase in the size of trading position. Margin trading paves the way for traders to invest more than they can afford.

What is Margin Trading?

Margin is the amount of money an investor deposits as a collateral with the broker to borrow the funds for trading activities. This margin covers the credit risk.

Margin trading literally means buying securities with borrowed money. In margin trading, an investor borrows the funds from a broker, which improves the trade in any financial instrument of their choice.

With the help of margin trading, a trader can buy stocks, bonds, and other financial instruments, which he initially couldn’t afford. Margin trading involves buying and selling of the securities within a single day, also known as “Intraday trading”.

How does margin trading work?

Margin trading is strictly governed by the Federal Reserve, the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). There are certain conducts that regulate margin trading.

When a trader buys securities on margin, he borrows money from the brokerage firms to pay the part or all of the purchase price of the securities with the agreement that you will repay the loan on time.

For an example: If you want to trade shares worth Rs. 1,00,000, but you have only the 80% of funds Which is (Rs. 80,000), then the remaining 20% of the amount will be provided by the broker that is Rs. 20,000.

An interest will be charged on the loan you are using. When you decide to sell your securities, the broker’s loan will be paid off first, and the remaining will be left with you.

Advantages of margin Trading

Margin trading is usually done by experienced traders as it has a high risk factor and they are quite familiar with the changing nature of the markets. For novice traders to start margin trading, they should have a thorough understanding of margin trading. Though risky, there are also some advantages of margin trading.

Leverage

The primary benefit you will get from margin trading is higher leverage, meaning higher purchase power. When you buy securities, there can be limitations due to the lack of funds, but with margin trading there will be the possibility of owning more profitable shares.

Flexibility

Margin accounts don’t have any fixed repayments schedules as long as you maintain the margin requirement set by the broker. You can repay the loan once you sell your stock.

Magnifies Profits

With the help of margin trading you can increase your profitability with more scope for buying on margin. The reason being, when the value of the securities increases, not only the worth of securities increases but also the higher value can act as collateral with more leverage for margin trading.

Risks of margin trading

There are certain risks associated with the margin trading:

Interest

When you borrow the money from the broker, it becomes a loan on which you have to pay interest. The rate of interest depends on the broker as well as the amount you borrow and on the market conditions. Margin interest rates start from 4.75% to 12%. Even if your stocks are performing poorly, you have to pay the interest.

Margin Calls

If the value of the security you own decreases, and your account equity goes below the minimum maintenance requirement, you will get a margin call. Then the broker will have to deposit extra cash to maintain the requirement.

Magnifies losses

The chances of incurring losses are higher in the margin trading. You can lose more than you invest if you are not aware of the markets.

Liquidation Risk

After the margin call, if you don’t deposit the money by the deadline. The broker has the right to eradicate the securities that were bought on margin. No notification would be sent, even if the loss is high.

Also Know: How to do Margin Trading from India

Conclusion

To be successful in margin trading, having ample experience in trading and understanding the functions of the market is very important. Once you get familiar with the market conditions, you can easily become a successful trader and earn profits.

This article tells all the ins and outs of margin trading. It has the potential to increase your profits and return on investments.

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