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What Is Margin Trading & When Does It Apply?

By Will Ellis
Last Updated on January 5, 2024

Generally speaking, any worthwhile opportunity that you’ll ever find when trading is going to come with some element of risk — it’s hard to become a profitable investor when you’re constantly applying a conservative strategy.

Fortunately, there are plenty of ways to make money in the markets, but perhaps no other avenue than margin trading is as high risk as it is high reward.

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As such, although it can potentially be a very lucrative way of trading, being able to properly trade with margin requires you to have an excellent understanding of the terms and fundamentals. In fact, the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) even have their own guidelines in place to protect investors.

So, throughout this article, we’ll be aiming to shed some light on how a few of these concepts work for any novice investors out there — walking you through how margin actually trading works, what the risks involved are, and even how you can plan out your own strategy.

Table of Contents:

Understanding Margin Trading ➡️

As touched on, let’s kick things off by getting some of the key fundamentals out of the way for anyone who doesn’t have any previous experience trading on margin:

Margin Trading Basics

Generally speaking, the simplest way to understand margin trading is to think of it as buying stocks (or even cryptocurrency) with borrowed funds rather than with your own cash.

Now, as you’ll probably be familiar with, this would typically never happen in traditional stock trading, as you’d generally only ever use your own cash to make an investment. Margin trading, on the other hand, works slightly differently, as you’ll be opening a specific margin brokerage account with a brokerage firm instead.

In essence, this gives you a new opportunity to borrow a portion (sometimes a fairly significant amount) of the purchase price, which naturally gives you a lot more leverage on your initial investment.

The Role of Margin Accounts

Going back to the ‘margin trading account’ we just mentioned, this is a concept you’ll need to get familiar with whenever you start trading on margin, as it distinguishes this kind of trading from your regular trading account and basically enables you to use borrowed money to increase your buying power/the size of your positions.

Ultimately, this means you’re able to control far more assets than you ever would’ve been able to with your own cash alone, so the potential for high returns is massively increased.

It goes without saying that this potential for increased returns is the main reason why margin trading is so popular in the first place, as it clearly offers a more exciting twist on regular investing — especially if you’re used to seeing a 10% growth in your investment portfolio every year, for instance.

Obviously, though, any semi-experienced margin traders know that enhanced opportunity to make money works the exact same way in reverse, giving you an equally high chance of losing your money.

As such, despite the thrill that comes with ‘homerun’ trades and possibly securing your daily trading in basically one trade, there’s an inherent layer of risk that comes with margin trading that makes it unique to regular investing — we’ll come onto these concerns in more detail slightly later in the article.

Initial Margin Requirements

So, once you’re ready to make your first margin trade, you’re going to need to meet what’s known as the ‘initial margin requirement’, essentially meaning the minimum amount of your own cash that you’re going to have to invest — borrowing a good chunk of the remainder from a brokerage firm.

Of course, it’s them that’s covering most of the heavy lifting, but you do still need to put up some amount of cash (depending on how big you want your position to be) to begin with.

This initial investment is just to serve as some kind of security on the trading platform’s behalf in case of any potential losses, and it’s a major part of margin trading worth getting your head around.

Margin Trading Mechanics 📊️

Now that we’ve got quite a few of the basics out the way and distinguished this kind of trading strategy from your typical idea of investing, let’s break down how to trade on margin more comprehensively in the next section of the article:

How Does Margin Trading Work?

You’ll, of course, have to find a brokerage firm that you like the look of first, but once you’ve opened your margin trading account with them, you’ll essentially be pledging any of the securities you already had as collateral for the margin loan.

The trading platform you’re using, in turn, gives you credit, which is how you’re able to make trades with borrowed funds in the first place.

So, the overall idea here is to be able to enter trades and make money with more than your own cash would ever allow you to, but you might still be wondering who this kind of service is actually suited for the most — beginner investors? Traders that have relatively small investment portfolios? Institutional investors looking to maximise the resources they already have available to them?

In reality, the answer is just anyone who feels particularly confident in their investment strategy and is entering a trade with a significant amount of conviction — whether that’s down to your own technical analysis or you simply have a hunch.

Obviously, this kind of investment strategy, while a great opportunity to access more capital if you’re a beginner investor, is geared towards people with slightly more experience and understanding of the risks involved, though.

Having said that, margin trading is available to anyone who’s interested in using it — most trading platforms make their users complete some kind of questionnaire regarding their risk management knowledge before they’re able to start trading, though, so make sure you come prepared.

Interest Rates and Margin Interest Rates

Moving forward, the interest rates that come with margin loans are another key part of this kind of trading, and the specific rate you’ll get is usually set by the brokerage firm itself (meaning it can vary).

Obviously, it pays to be aware of these margin interest rates, as they actually have a direct impact on the overall cost when borrowing money for buying on margin.

Understanding Margin Calls

A margin call is something that pretty much every investor fears, as they’re essentially a demand from your brokerage firm that you need to deposit additional funds or even securities to cover your potential losses.

So, if you’re unable to meet these calls, it actually means that you might be forced to sell some of your assets at unfavourable prices.

Risks and Considerations 🤔️

Although margin trading is probably one of the fastest and most exciting ways to make money as an investor, we’d be doing you a disservice not to talk about all of the main reasons you might be better off steering clear of margin trading.

So, let’s wrap things up by walking through some of these concerns:

Trade on Margin Responsibly

Generally speaking, it’s incredibly easy to be enticed by margin trading if you’re someone with a relatively small investment portfolio. Naturally, it can be very frustrating to make what’s widely considered a good trade — say, 1-2% ROI, for instance — and walk away with essentially pennies after the transaction fees, etc.

So, although margin trading turns this 1-2% figure into something much more substantial, this is definitely a trading strategy that you should approach with caution — only ever trading on margin if you have a genuine understanding of what kind of risks are involved.

There are certainly more factors, but in order to responsibly margin trade, you’re going to need to adopt a few risk management strategies — whether that’s only ever staking a particular percentage of your trading portfolio or only investing in companies/assets that you have experience with.

Psychological Impact of Losses

This is probably something that has more of a detrimental effect for the novice traders that are reading this article, but experiencing losses in margin trading — or any kind of trading for that matter, it’s just amplified because of the higher stakes — can actually have pretty profound impacts on your confidence and ability to trade.

It usually depends on the amount of cash that you lose, but some of the stress and anxiety that comes with a major financial setback can absolutely cloud your judgement next time you trade, ultimately leading to much more impulsive decision-making.

As a trader, it’s generally considered a golden rule to never trade with your emotions, and nowhere else is this more true than in margin trading.

As such, just make sure you’ve got a fairly well-defined strategy for handling both wins and losses — not overreacting when you make a highly profitable trade but never breaking down and ‘revenge’ trading if the markets don’t go your way, either.

Unlimited Liability and Negative Balances

Moving forward, a concept that you’ve perhaps never been introduced to when trading without credit is something known as ‘unlimited liability’, which essentially means that there’s a chance you end up losing even more money than you initially invested.

Put simply, if the value of any of the securities that you’ve been trading in your margin account declines enough, it can actually lead to a negative balance. In these kinds of cases, the onus would actually be on you to cover the deficit (known as maintenance margin requirements), and that’s even if it exceeds the amount you’ve initially invested.

Obviously, this can be a pretty unfamiliar concept for most traders and a frightening one at that. So, if this is something that you’re not financially equipped to handle or recover from, it’s probably best that you stay away from margin trading altogether and focus on something slightly more conservative instead.

Lack of Investor Experience and Knowledge

As touched on earlier, margin trading is a little bit more complex than regular investing, which can definitely leave novice traders at a disadvantage due to a lack of experience/knowledge — generally leading to poor decision-making and risk management.

Ultimately, you should try to think of margin trading as something completely new if you’re not a seasoned investor, which naturally means you need to educate yourself all over again and maybe start off slow with a bit more of a conventional investment strategy.

FAQs 📢️

Can Anyone Open a Margin Trading Account, or Are There Specific Requirements?

Margin trading accounts tend to be available for most people, but still, not everyone can open one — there are usually eligibility criteria set by the brokerage firm, considering things like financial stability and trading experience. You’ll need to check with your particular brokerage firm of choice to know what their specific requirements are for opening a margin trading account.

How Does Trading on Margin Impact an Investor’s Overall Portfolio?

Generally speaking, you should fairly carefully consider what proportion of your portfolio you want to dedicate specifically to margin trading, as any losses you make in your margin account can naturally have a much more pronounced effect on the overall stability of your investment portfolio.

Are There Alternatives to Margin Trading for Investors Seeking Leverage?

Of course, there are a bunch of different ways you can access leverage as an investor — futures, options trading, and leveraged exchange-traded funds (ETFs) being some of the more popular ways you can amplify returns without directly borrowing funds, for example. These alternatives come with their own set of risks and complexities, though, so make sure you know how these work, too.

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