Risks and Benefits to Margin Trading - DIVINE (2024)

FAQs

Are there any risks to margin trading? ›

While margin loans can be useful and convenient, they are by no means risk free. Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.

On the positive side, margin trading offers increased buying power, leveraged profit potential, and short-selling opportunities. However, it comes with increased risk exposure, interest payments, potential margin calls, emotional stress, and susceptibility to market volatility.

The biggest risk from buying on margin is that you can lose much more money than you initially invested. A decline of 50 percent or more from stocks that were half-funded using borrowed funds, equates to a loss of 100 percent or more in your portfolio, plus interest and commissions.

Margin trading is risky since the margin loan needs to be repaid to the broker regardless of whether the investment has a gain or loss. Buying on margin can magnify gains, but leverage can also exacerbate losses.

The risk is that margin trading might induce you to take positions larger than you can afford. In such cases, if your position is not properly managed, it could backfire and the losses could mount so rapidly that the entire trading capital can get wiped out in no time.

Cash & Borrowing Margin — How much money do you have available to withdraw that includes cash along with the loan value of the securities held in your margin account? Amount withdrawn that exceeds your cash will be a margin loan and therefore will accrue interest.

Especially for beginning investors, it's best to avoid trading on margin since it's not always clear how much you've borrowed from your brokerage and how much you have in equity, plus it's easy to think of all of your holdings as your money even if much of it is borrowed.

Margin interest rates are typically lower than those on credit cards and unsecured personal loans. There's no set repayment schedule with a margin loan—monthly interest charges accrue to your account, and you can repay the principal at your convenience.

This essentially doubles your buying power. Imagine that you have $5,000 cash in your brokerage account and you want to buy a stock priced at $100 per share. With a cash account, you could buy up to 50 shares. A margin account may allow you to buy up to 100 shares worth $10,000, meaning you'd owe the broker $5,000.

Components of Margin Trading

You can keep your loan as long as you want, provided you fulfill your obligations such as paying interest on time on the borrowed funds. When you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid.

What happens if you don't pay back margin? ›

If You Fail to Meet a Margin Call

Should the account holder choose not to meet the margin requirements, the broker has the right to sell off the current positions.

If you aren't able to meet the margin call fast enough to satisfy your broker, it may be able to sell securities without your permission in order to make up for the shortfall. You will typically have two to five days to respond to a margin call, but it may be less during volatile market environments.

Risk of Higher Losses

It is even possible for a margin trader to lose more money than they originally had to invest—meaning that they would have to make up the difference with additional assets.

Buy gradually, not at once: The best way to avoid loss in margin trading is to buy your positions slowly over time and not in one shot. Try buying 30-50% of the positions at first shot and when it rises by 1-3%, add that money to your account and but the next slot of positions.

A general rule-of-thumb for the amount of margin capacity is to use 50% as the loan-to-value ratio. The loan-to-value ratio could vary by custodian and based on the type of asset being used as collateral.

When investing on margin, the investor is at risk of losing more money than what they deposited into the margin account. This may occur when the value of the securities held declines, requiring the investor to either provide additional funds or incur a forced sale of the securities.

While margin trading offers higher potential for profits but also exposes you to higher potential for losses, futures trading is more stable in results. The difference between margin trading and futures trading lies in the ownership of assets, risk and leverage, timeframe, and price determination.

There is additional risk in borrowing to invest. If the market or your investments drop in value, then you won't only be dealing with that loss - you'll also have to repay the loan. Although the additional market exposure has the potential to magnify returns, it also has the potential to magnify losses.