With margin account, investors can borrow from the broker the value of assets they already hold to sell short or purchase new positions. In bullish or bearish conditions, investor can leverage their margin account. Cash withdrawals can also be made against margin account value for a short time.
To choose an online broker, you looked at the account minimums, commissions, fees, promotions and even ensured that the platform suits your tech needs and trading style but want reassurance from experts. Fortunately, there are trading review sites and forums that can help you. An active online trading forum is a platform where investors and traders share ideas, strategies, trading news & analysis, and even answer questions about a specific broker. You will even get to learn a lot about margin trading potential benefits and possible risks.
Primary benefits of margin trading
Opportunity to leverage
Margin trading allows trader to leverage the worth of already owned securities and increase investment size. Thus, your potential to amplify returns increases, if the market moves in your favor.
For example, you have securities worth $20,000. The $10,000 is paid in cash, while the other $10,000 is borrowed. When the value of these securities rises by 25% then you profit $5000. Now, the borrowed amount from your broker remains at $10,000 nevertheless your equity increased by 5,000 and your margin account holds a total of $15,000. This means 50% growth rate.
Chance to short sell
With margin account borrow shares, sell them and buy back at later date. For example, you borrow a company’s 100 shares then sell it short at $60 per share for total of $6,000. After four months, the share price falls down to $50. You buy 100 shares at $50 [$5,000] and return the borrowed shares to brokerage firm. The difference in profit counts to $1,000.
Other benefits of margin account
- Diversify concentrated portfolio
- Convenient credit line
- Low interest rates
- Repayment flexibility
- Tax-deductible interest
- Increase cash dividends
- Trading flexibility
Possible risks with margin trading
Margin can amplify your losses as intensely as it is capable to increase your returns.
Margin call risk
The brokerage platform needs you to maintain specific amount in your account. It depends on the type of assets you own and if you want loan to buy extra securities or sell short.
For example, your margin account has securities worth $15,000 and borrowed amount is $10,000. Your minimum equity maintenance balance will be approximately 33% or $5,000. [Total account value – margin loan balance = minimum equity maintenance need]
If the stock values used as collateral for margin loan plummets below minimum equity maintenance need then your account incurs margin call. It means you will have to add securities or cash to your account and increase equity. In case, you fail to do this the broker will sell your securities without notifying you, so as to increase account equity balance.
How to handle the potential risk of margin account?
- Leave extra cash in the account to decrease the possibility of margin call.
- Invest in securities revealing significant return potential that is make you earn more than loan interest cost.
- Prepare your portfolio for volatility.
- Set personal trigger points.
- Pay interest regularly to avoid them accumulating to unmanageable levels.