The meaning of buying stocks on margin simply refers to borrowing money from your broker to buy the stock and securing transaction with a small deposit instead of paying the full value of the stocks purchased. When you trade stocks on margin, you can maintain a much larger position or buy more stocks above your trading capital. By using such leverage, you can make larger profits easily but it is also possible to lose all your money in a single day due to the increased risk.
When you trade stocks with a margin account, your stocks are used as collateral for the loan and your broker can actually force sell them without your instruction in order to safeguard their interest and recover the loan money. However, this risk can be reduced with proper money management and avoiding high risk leverage.
Usually, you will borrow money from your broker, which acts as the lender, via a margin trading account. Brokers will only lend a certain percentage of your trade value, such as 60%. In that case, you need to pay for the other 40% using cash.
So if you intend to enter a long position in a stock that is trading at $100 per share and you want to long 100 shares, the total cost will be $10,000 using a normal stocking trading account. However, if you do not have that much cash to trade such a big position, a margin trading account can lend you 60% and thus you only need to pay $4,000 up front for the same trade.
It is important to understand your account equity which is the difference between the amount borrowed and the current value of your stocks. Any increase in the stock price after your purchase will also increase your equity since they are worth more now.
You need to be careful and maintain sufficient equity such that it is more than 40% of the original trade value, otherwise a margin call will be triggered and your broker can sell off the stocks held in your account to recover the loan. This usually happens when the trade moves against you such as the stock price dropping after you bought in. The best part is that your borrowing costs are so much cheaper compared to other unsecured personal loans available and most brokers allow you to borrow $100,000 or more.
A margin call happens when your lender or broker require you to top up your trading account so that your total loan is lower than 60% of the current stock price. If you fail to do so within a day or two, the broker can exercise their right to sell off your shares to recover the loan money. Any further drop in the stock price will result in the value of your shares been reduced to less than the loan value.
Continuing with the above example, the stock price has dropped to $95 instead of rising as you expected and your total investment is reduced to to $9,500. The $6,000 loan has increased to become 63.2% (6,000 divided by 9,500) of your investment while your equity dropped to 36.8% (100% minus 63.2%). Your broker will inform you to pay $300 to reduce the loan balance to $5,700, which is back to 60% of the trade value (5,700 divided by 9,500).
If you choose to borrow less than 60% of the total trade value, you can withstand a larger drop in stock prices before having to meet a margin call. This is especially important in volatile market or when prices are currently swinging within a trading range instead of a strong upwards trend.
Margin calls are the main reason why many beginners and new traders lose money. However, purchasing stock on a margin is still very attractive due to the advantages of leverage when used properly.
If you have thoroughly studied a company’s fundamentals and recent stock movements to conclude it will be moving strongly in a particular direction within the short term, you will want to trade a larger position (i.e. buy more stocks) in order to maximize your profits after spending so many hours studying the stock charts.
However, if you only have $5000 to invest in a $100 stock, you can only buy 500 shares and your profits are thus capped. On the other hand, buying with a margin account allows you to borrow another $5000 to buy 1000 shares and double your potential profits. However, if the stock price drops before it rises and triggers a margin call, your broker will force sell your shares and you incur a heavy loss. When you buy a stock with cash, you can choose to hold it despite falling prices until it moves back in the money as anticipated. Never take a easy credit personal loan just to meet a margin call, just accept the loss and cool off.
You can make money trading stocks on margin, however the secret is in avoiding over-leverage. Otherwise, a small drop in the price of your stock can quickly stop you out of the trade for a loss. Many investors on margin accounts had their stocks sold below market price during the 2008 market crash to meet margin calls, and this actually further drives down the falling stock prices.