 that stock increases 50 percent in value in the next six months, your investment would be worth $1,500.
If you invest on margin, and you can buy 200 shares of stock instead. After the same timeframe, you’ll have $3,000, doubling your investment return. Or, you could buy the 100 shares on margin and have cash available for another investment. A lower initial cash investment gives you the flexibility to diversify into other investments. Also, increased diversification can help provide insulation against risk. Having more cash on hand to trade also means you’re not forced to liquidate other investments to buy additional shares.
Competitive interest rates – Margin interest rates can be very competitive and attractive. This is due to the fact there is always collateral available. Also, your broker holds the securities and is paid first before you receive any profits from sales.
Trading flexibility – Being able to invest more while having limited cash on hand allows you to take advantage of timely market opportunities.
Diversification – Margin trading enables you to diversify your portfolio by using the margin buying power if you hold a concentrated stock position in your account.
Are there Downsides to Margin Trading?
At first glance, it sounds great to trade with leverage and borrow capital from your broker to trade bigger. But you need to know that there can be a big downside from trading with margin. It doesn´t mean that you can only lose the small percentage your broker requires as margin to open the position. In fact, your entire account can be wiped out.
Increased risk – This is the most obvious disadvantage of trading with margin. To control a much larger position on margin means that the profits can bigger but so can the losses. This is why you must be careful. Follow very strict risk exposure and money management rules when using margin.
Stress – Some traders can’t handle the stress of having too large of a position open. Fluctuation in their unrealized profit or losses is too big. This can lead them to take irrational decisions. Letting emotions influence your trading decisions will make you lose money in the long term. If you can’t handle big fluctuations, then you should start with smaller positions sizes.
Margin calls – To get a margin call from your broker means that your equity is too low. It can´t support the minimum margin requirements from your broker. You need to top up with additional cash, or your trade will be closed with a loss. In either case, it leaves you with a smaller percentage of your initial equity.
Margin trading lets you open a big position with just a small percentage of its actual value. This is because of the leverage you are provided by borrowing from your broker. But this doesn´t mean that you can only lose the small percentage your broker requires as margin to open the position. In fact, your entire account can be wiped out.
A margin call is also known as a maintenance call. It is when your brokerage asks you to add more cash to your margin account. This occurs when your account value drops due to a decline in stock price. A margin call can happen immediately after your account’s equity value falls below a certain threshold. Brokerages typically require a baseline of 25 percent. This means you must have at least 25 percent equity of the securities in your account. Some firms have a threshold as high as 40 percent.
Your brokerage isn’t required to notify you of a margin call. However, many will try to contact you by phone or email. Also, they don’t have to give you time to add money to your account, but some might. You can respond to a margin call by making a deposit, topping up your equity sufficiently. Otherwise, your broker can sell the shares of its choosing in your margin account to make up the difference.
Leverage is the increased “trading power” that is available when using a margin account. Leverage allows you to trade positions LARGER than the amount of money in your trading account. To use leverage in trading, the trader need only invest a certain percentage of the whole position.
Let’s say that you deposit $50,000 in your margin account. Because you put up 50% of the purchase price, this means you have $100,000 worth of buying power. For example, you can buy $50,000 worth of stock by putting up only $25,000 of your cash and using margin for the other $25,000. You still have $50,000 in buying power remaining. Or, you have enough cash to cover this transaction and haven’t tapped into your margin. You start borrowing the money only when you buy securities worth more than $50,000.
In business accounting, margin refers to the difference between revenue and expenses. Businesses typically track their gross profit margins, operating margins, and net profit margins. The gross profit margin measures the relationship between a company’s revenues and the cost of goods sold (COGS). The operating profit margin considers COGS and operating expenses and compares them with revenue. The net profit margin takes all these expenses, taxes, and interest into account.
Adjustable-rate mortgages (ARM) offer a fixed interest rate for an introductory period, and then the rate adjusts. To determine the new rate, the bank adds a margin to an established index. In most cases, the margin stays the same throughout the life of the loan, but the index rate changes. For example, consider a mortgage with an adjustable-rate. It has a margin of 3% and is indexed to the Treasury Index. If the Treasury Index is 4%, the interest rate on the mortgage is the 4% Treasury index rate plus the 3% margin, or 7% total.
Up Next: What Is a Dow ETF vs Dow Jones ETF?
An exchange-traded fund (ETF) is a type of security that involves a collection of securities, such as stocks. Often this collection of securities is designed to track an underlying index. However, they can be structured to track any number of industry sectors or use various strategies. A Dow ETF, or Dow Jones ETF is an exchange-traded fund that tracks the Dow Jones Industrial Average Index. ETFs in many ways are similar to mutual funds. However, they are listed on exchanges. As a result, ETF shares trade throughout the day just like an ordinary stock.
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