Many people are attracted to the investing world by margin or borrowing money from a broker. And for good reason. Margin can increase your buying power, for the possibility of increased gains.
But when it comes to Wall Street, there’s no such thing as a free lunch. Margin can be just as harmful as helpful. Ask anybody who’s ever blown up an account.
So before you add some margin to your account, ask yourself these questions.
Margin is essentially a loan from your broker. Once you open a margin account and deposit cash into it, you’re allowed to borrow up to 50 percent of the purchase price of a stock.
Your margin and cash amounts are added together to calculate your total buying power. So someone with $10,000 in a cash account and $10,000 in a margin account would be able to buy $20,000 worth of investments.
Anybody with margin is required to maintain a minimum balance in that account, typically $2,000, as mandated by federal regulations. But that minimum balance might actually be greater depending on your broker. Your margin account balance is not something you should lose track of, for reasons we’ll cover later.
The biggest advantage to margin trading is the huge boost to buying power outlined above. This increased buying power can also provide you with more flexibility. A small trader with only $2,000 in cash will be limited in what they can buy, and how much.
But with margin, that same trader could comfortably increase the number and size of their investments.
Finally, margin accounts typically provide a number of options that aren’t available to traders with only cash accounts. Margin traders favor decreasing stock prices or hedge long positions by short-selling. They can also gain leverage by trading options contracts.
The increased exposure offered by margin is the very same thing that makes margin risky. With margin, you can win bigger, and lose bigger.
And, just as with any loan, it’s not free. Margin traders pay interest on the margin they use, and that interest can eat into potential market gains.
If the market does go against you, and the balance in your margin account gets too low, you may be subject to a margin call. A margin call is a risk management mechanism used by brokers to protect them from losses endured by reckless traders. When a trader’s account value dips below a certain level, brokers can force you to either deposit more cash in the account or they will automatically sell your investment at the current market price, setting you up for a loss.
As with any other trading strategy, there is plenty to consider about margin trading prior to making that first trade. If you can confidently answer these three questions, and you’ve figured out how using margin fits into your broader trading strategy, personality, risk profile, and time horizon, then you’re ready to make your first trade on margin.
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