Margin Trading: What is Margin and How does Margin Trading works?
Investment is a great and Interesting concept and so many people have adopted it as a way of making good use of their money. Going into investments, however, requires you to be a good researcher and to understand all the concepts well to ensure that you are not exposing yourself to huge risks. One of the concepts involved in investing is what is called Margin Trading, Have you heard of it before? Would you like to know more about it? Hang in there! In this article, we shall bring to you everything you need to know about Margin and Margin Trading.
1. What is Margin?
A margin in financial terms is the initial deposit that an investor pays their broker when they borrow money from the broker to buy commodities, stocks, and others. It is a deposit made to cover the financial risk that an investor exposes the broker to due to borrowing from the broker. To understand the concept of margin better, you can see it as a form of using the securities or cash you have in your account as collateral for a loan. This loan thereby comes with a certain interest rate that must be paid at a certain period. Margin trading is a very good one in situations where the investor expects higher earnings on the return on investment as this would cover up the amount of interest that he is paying on the loan. Where the risk comes to play is when the return on investment is even lower than the interest he has to pay on the loan- that is a form of loss.
2. What is Margin Trading?
Now that you have understood what margin is in and of itself, then you can easily understand margin trading, also known as margin investment, as a way of trading financial assets that serve as collateral with borrowed funds from a broker or trader. These financial assets serve as collateral for the loan from the broker.
To start margin trading or investment, you have to have a margin account that is different from the normal cash account. A margin account allows the investor access to a larger amount of money to buy commodities much more than the investor would ordinarily afford. According to the law, your broker necessarily has to seek your consent before going ahead to open a margin account. Once your consent is sought and you have approved it, the margin account is opened and you would be needed to make pay an amount known as the minimum margin into the margin account. A minimum margin is an initial investment that is up to at least $2000. This is the minimum for most brokers though some of them ask for higher amounts. After the margin account is open and you have funded it, you are free to borrow up to fifty per cent of the purchase price of a commodity. That particular amount of the purchase price that you deposit is what is called the initial margin.
Once you stick to the regulations and you fulfil all obligations like paying the interest on the borrowed fund as at when due, you are free to keep your loan for as long as you wish. You should note that the proceeds are directed to your broker for repayment once you sell the stock in a margin account, this continues until the loan is fully paid. There is a minimum account balance that you have to maintain before your broker forces you to either sell your stock or deposit more funds to pay your loan- this minimum balance is known as the maintenance margin. If your broker has to ask you to sell your stock or deposit more funds to pay your loan, then this process is what is called the margin call. If you are not able to fulfil the margin call, your brokerage firm has the right to close down any account to push the account up to the required minimum value level. You can also be charged a commission for the transaction; again, you are liable for any type of loss incurred in the course of the whole process. One of the well-known limitations of margin trading is the fact that you are taking a loan and you have to pay interest on the loan; this interest may increase over a particular period.
3. What other sectors adopt the use of Margin?
3.1 Mortgage Lending Margin
In mortgage lending, there is the concept of the ARM which is known as the Adjustable-Rate Mortgages. The ARM provides a fixed interest rate for an initial period, and this rate later adjusts. To determine the new rate, the bank adds a margin to an already established index. Mostly, this margin remains the same all through the time of the loan through the index rate changes.
3.2 Accounting Margin
Margin is also used in business accounting and it simply means the difference that is between the revenue and the expenses. It is used by businesses to track their operating margins, gross profit margins, and net profit margins. The operating profit margin shows the COGS and the operating expenses and then makes a comparison between them and the revenue. The gross profit simply calculates the relationship that is between a company’s revenues and the cost of goods sold, also known as the COGS. And the net profit margin takes into account, all the interest, taxes, and expenses.
4. Pros of Margin Trading
4.1 It is a good means of making large Profit
Because margin trading allows you the chance to take high trading positions, it is a good way of making very large profits easily. It affords you the chance to borrow shares, sell them, and then buy them back at lower rates in the future. Your profit is simply the difference between the price of the borrowed shares and the price you later get to buy them.
4.2 It is a good Means of Diversification
Margin trading is a very good way of diversifying one’s portfolio and so it is a good option for investors that value having a diversified portfolio. Margin Trading allows room for diversification by affording traders to open lots of positions with a reasonable small amount of investment capital. This is one of the ways that investors adopt diversification.
4.3 It makes Opening of Positions Easy
One other very amazing advantage that margin trading has is the fact that it allows traders to easily open positions very fast without having to go through the stress of moving large amounts of money into their accounts. This alone is one of the reasons why so many traders consider the option of margin trading as it makes things easy for them.
4.4 It comes with Low-Interest Rates
Even though margin trading comes with interest rates just like any other loan, the interest rates on margin trading are usually lower and so this allows you to enjoy a low interest rate on your trade.
4.5 Repayment is Easy
As long as your debt does not get higher than the required margin maintenance, you have the opportunity to repay your loan at any time of your convenience.
5. Cons of Margin Trading
5.1 There is the risk of not meeting up with the margin call
Once this happens, your brokerage firm has the right to close down any account to push the account up to the required minimum value level. You can also be charged a commission for the transaction; again, you are liable for any type of loss incurred in the course of the whole process.
5.2 The risk of having to pay Increased Interest Rate
Just like any other loan, margin trading involves that you pay a certain amount of interest on your loan. This interest tends to increase over a certain period.
5.3 It is a high-risk Trading Method
This means that a little drop in the price of the market can lead to great losses for traders. Though Margin trading is a very good one in situations where the investor expects higher earnings on the return on investment as this would cover up the amount of interest that he is paying on the loan. Where the risk comes to play is when the return on investment is even lower than the interest he has to pay on the loan. The investor would be incurring losses in this case.
6. How to Manage a Margin Account Risk
All forms and kinds of investments come with a certain amount of risk. To manage the risk that comes with having a margin account, you can follow the following rules:
The first thing you need to make sure of is to always leave a spare amount of cash in your account to reduce the risk of you getting a margin call, another thing is to always prepare for volatility by building your portfolio in a way that it withstands certain fluctuations in the value of your collateral so that even with fluctuations, it still would not fall below the minimum equity requirements. Lastly, ensure that you do not leave your interests unpaid so much that they do not get to amounts that are too weighty to bear.
Margin Trading is one of the various options available for investors and it sure has a lot of benefits. It is one of the easy ways to makea huge profit and to have a diversified account. Be sure to make use of good mitigation tools to reduce your risk potentials.