Buying On Margin — Risks & Opportunities Explained

In this article, we'll explore what margin trading is, how it works, and why it can be a valuable addition to an investor's toolkit.

Updated: January 3, 2024
Matt Crabtree

Written By

Matt Crabtree

 

Online trading is becoming increasingly popular as a means of investing and making money. An exciting and potentially lucrative way of trading is buying on margin, also known as leveraging.

Buying on margin increases the exposure that an investor has to an asset, and while this can be a highly profitable method of trading, it can be risky if not done correctly.

In this article, we'll explore what margin trading is, how it works, and why it can be a valuable addition to an investor's toolkit.

Margin Trading & How It Works

Simply put, margin means borrowing money from a broker to buy an investment. This borrowing is covered by a margin account, funded by the investor's funds and any profits earned from the investment.

The amount of money that can be borrowed is determined by the margin account's total assets and a margin rate set by the broker.

Once the margin account is funded, you can use the borrowed funds to purchase an asset, such as stocks, bonds, currency, or futures contracts. This leverage provides access to more capital than they would otherwise be able to access, which can lead to very profitable trades.

The key to success with a margin loan is using it judiciously. Investors should be well-versed in their chosen asset and understand how their trades will affect the balance of their brokerage account. You should also understand the risks involved in a margin loan and be prepared for market changes and the potential for losses.

The bottom line is that margin trading is a powerful and potentially profitable trading strategy, but it can also be risky. As an investor, understanding how margin loans and the associated risks is crucial before you decide to use this type of trading strategy.

Analysing The Different Types Of Margin Account 

Cash Account

This form of margin account lets you borrow money from your broker and use it to purchase stocks and other financial instruments. Conveniently, Cash Accounts can be used to invest in stocks without putting up any of your own money. Despite this, you will, unfortunately, be charged interest on the amount you borrow.

Collateralised Account

This type of account is similar to a cash account in that you can borrow money from your broker to purchase stocks. However, you must put up collateral in cash or securities instead of paying interest on the money you borrow. If your collateral falls below the maintenance margin value, the broker will be able to sell the collateral to recoup its losses.

Margin Loan

This is where the broker lends you money at an interest rate usually higher than what you could get from a bank. The advantage of this type of account is that it allows you to use leverage, which means you can buy more stocks than you would otherwise be able to with just cash. However, if you don't repay the loan, the broker can take back the stocks and sell them to get its money back.

Marginable Securities Account

Finally, there is the option of a marginable securities account, which is similar to a cash account except that you can use the securities you own as collateral for the loan. This type of margin account is ideal for traders looking to invest in stocks regularly but want to avoid putting up cash as collateral. The downside is that you may be charged higher interest rates than you would with a cash account.

How To Get Started With Margin Trading

First of all, you'll need to open a brokerage account. Brokerage accounts are typically available through banks and brokerage firms. Most firms will require you to provide financial information and fill out a few forms. It is crucial you understand the risks and responsibilities associated with borrowing money before you open an account.

After opening a brokerage account, you have to set up a margin account. Margin accounts are used to borrow funds from your broker to buy securities. Your broker will typically require you to have a minimum deposit to open a margin account, usually higher than the minimum required to open a regular brokerage account.

It's important to note that while you are borrowing funds to purchase securities, you are still responsible for any losses that occur.

Next, you must decide which securities you want to purchase. You can buy stocks, bonds, mutual funds, or another type of investment, but it's essential to research which kind of security is best for you.

Once you have decided which securities you want to buy, you will need to determine how much margin you want to use. The amount of margin you use will determine how much leverage you will have in your initial investment. As with any investment, it is important to only use as much margin as you feel comfortable with.

Finally, once you have chosen the securities you want to buy and the initial margin to use, you can begin trading!

Is Buying On Margin Worth It?

Buying on margin has become a popular investment strategy for many traders and investors, offering the potential for greater profits in return for taking on higher risks.

It's easy to become enamoured with the prospect of margin trading, given its ability to maximise profits in a volatile stock market.

However, it's essential to understand the potential risks that accompany these high returns. Let's take an in-depth look at margin trading and weigh the potential pros and cons of using this popular trading technique.

Benefits

Day trading is an exciting, fast-paced approach to trading that can be quite lucrative and risky. One way that day traders can manage risk and potentially increase their profits is through margin trading. 

Increased Leverage

One of the main benefits of margin trading is its increased leverage. When using margin, a day trader can borrow money from a broker and use it to increase the size of a trade. This means you can make larger trades without putting up all the capital to do so. 

Of course, with increased leverage comes increased risk, and margin trading can lead to higher losses if a trade goes wrong. Therefore, it is vital for day traders to use margin trading responsibly and to make sure they are comfortable with the increased risk.

Easier Access To Profits

Another benefit of margin trading is that it can allow for quicker profits. When trading with margin, gains can be realised more quickly as the trader can use the borrowed money to increase the size of their trades. This can be a valuable tool for day traders looking to access their profits in a timely manner.

Increased Utility

Finally, margin trading can increase the utility of a day trader's capital. By using margin, a day trader can increase the size of a trade and potentially make more money from the same amount of capital. This can be beneficial for those looking to maximise their profits from a given amount of capital.

Risks

Margin trading is a risky investment vehicle that can either pay off significantly or lead to major losses. In order to maximise their chances of success, investors need to understand the risks associated with this type of trading.

Let's explore the potential risks of margin trading and how investors can manage them.

High Leverage

The most obvious risk of margin trading is the high leverage that comes with it. Leverage is a double-edged sword that can dramatically magnify returns as well as losses, making it a potentially risky endeavour.

Market Volatility

Since margin trading relies on borrowed money, there is an additional risk of market volatility. If the value of the margin trades goes down, investors may be required to provide additional funds to keep their position open. This can result in losses that are far greater than would have been incurred with a standard trade.

Slippage

This is the difference between the expected trade price and the actual price at which it is executed. This can be a problem in margin trading because the order size is often much larger than in a standard trade. This can lead to an unexpected loss in value if the trade is not filled at the expected purchase price.

Margin Call

When an investor is faced with a margin call, it can be an unsettling and potentially catastrophic event. A margin call occurs when an investor's account does not have sufficient funds to maintain the required level of margin.

If the investor does not respond to the margin call in a timely fashion by either adding funds or selling securities held in the account, their broker may liquidate their portfolio without their consent.

For many investors, a margin call can be considered an existential crisis. Not only can it put their financial security at risk, but it can shake their trust in the markets and their decision-making ability. It can lead to intense feelings of panic, guilt, and even shame, which can cause serious disruption to their life — both on a financial level and psychologically.

The most common cause of margin calls is the over-use of leverage in an investment portfolio. Investors use leverage to increase buying power , it should not be underestimated in terms of the associated risks. If an investor takes on too much leverage, they can quickly find themselves in a situation where their account is forced to a margin call.

Managing The Risks Of Margin Trading

1. Understand Your Goals

Before engaging in margin trading, it is important to understand your goals and risk tolerance. This will help you to properly assess the risks of the trade and the likelihood of achieving your desired returns.

2. Use Stop Losses

A stop loss order is a kind of trade that automatically closes your position if it reaches a certain level of loss. This can help to limit your losses in the event of a sudden market shift.

3. Diversify Your Portfolio

Diversification is key to any successful investment strategy. In margin trading, it can be helpful to spread your investments across multiple assets in order to reduce the risk associated with any one position.

4. Dealing With Margin Calls

The key to avoiding margin calls is to make sure that you constantly remain in control of your investment portfolio. Make sure that you manage your risk by taking into account your personal goals and financial objectives.

Regularly check the status of your portfolio, and ensure that you understand the concept of leverage, as this can be a powerful tool when used correctly but can also be detrimental when used incorrectly.

Investors should not be too hard on themselves when they face a margin call. Instead, they should look at it as a valuable learning experience and use it as an opportunity to reflect on their decision-making process. It's important to remember that everyone makes mistakes, and a margin call does not have to be the end of your investment journey.

Margin trading offers investors the opportunity to amplify their returns, but it can also be dangerous. By understanding the risks associated with margin trading and utilising risk management strategies, investors can better manage their risk and maximise their potential returns.

Related Guides:

Related Articles

Pepperstone Review
Generally speaking, whether you've been trading various financial instruments for...
Best Free Trading Platforms
Top free trading platforms in the UK offer multiple benefits. If you're interested...
Best Demo Trading Accounts
If you are interested in trading various financial instruments but are unsure how...
Best Investment Platforms
If you're new to investing, you’ll want to choose an investment platform that’s...