In our previous article, we learned about the process and components of margin trading trading. In this article we shall be diving into the pros and cons of Margin trading. Lets jump right in.
Advantages and Disadvantages of Margin Trading
Advantages
- Leverage may lead to bigger profits.
- Boosts the purchasing power.
- Usually gives you more flexibility than other kinds of loans.
- May be a self-fulfilling cycle of opportunities, where an increase in the value of collateral leads to more chances to use leverage.
Disadvantages
- May cause bigger losses because of leverage
- Account fees and interest charges are incurred.
- May cause margin calls that require more equity investments
- May lead to forced liquidations, in which securities are sold (often at a loss).
Pros
The main reason buyers trade on margin is to make money by using leverage. Margin trading centres help people buy more things by making more money available to buy stocks.
Instead of buying securities with money they already have, buyers can buy more securities by using their capital as collateral for loans that are larger than their capital.
Because of this, trading on margin can increase income. Again, when you have more securities, gains in value have bigger effects because you have more debt invested.
Also, if the value of the shares you put up as collateral goes up, you may be able to use leverage even more because your collateral basis has gone up.
Margin buying is also often easier to change than other kinds of loans. There may not be a set schedule for making payments, and your broker may have easy or automatic maintenance margin requirements.
Most margin accounts keep the loan open until the securities are sold, when the borrower usually has to make the final payments.
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Cons
If buyers use margin trading to increase their profits, they should know that it also increases their losses.
If the value of securities bought on credit drops quickly, an investor may give more money to lenders than just their initial equity investment.
Margin trading also costs money. Brokers usually charge interest fees, and you have to pay them no matter how well (or badly) your credit account is doing.
Investors may get a margin call because they need to meet margin and equity standards.
This is a requirement from the broker that they put more money into their trading account because the value of the securities they own has gone down.
Investors need to be aware that they will need this extra cash on hand to meet the margin call.
If investors can’t put in more money or if the value of an account drops so quickly that it falls below certain margin standards, the account may be forced to be liquidated.
With this forced liquidation, the assets bought on margin will be sold, which could lead to losses to meet the broker’s requirement.
Margin: An Example
Let’s say that you put $10,000 into your balance account. Since you paid half of the price up front, you have $20,000 worth of buying power.
Then, if you buy $5,000 worth of stock, you still have $15,000 in buying power left over. You have enough cash to pay for this deal, and you haven’t used up any of your margin.
When you buy stocks worth more than $10,000, you can start borrowing money.
Note that the amount of money you can buy with a margin account changes every day based on how the prices of the securities in the account change.
Other Ways That Margin is Beign used
Accounting Margin
In business accounting, a margin is the difference between revenue and costs. Businesses usually keep track of their gross profit margins, operating margins, and net profit margins.
The gross profit margin shows how much money a company makes compared to how much it spends on things sold.
Running profit margin looks at COGS and running expenses and compares them to revenue. Net profit margin looks at all of these expenses, taxes, and interest.
Mortgage Lending Margin
Adjustable-rate mortgages (ARMs) start out with a set interest rate, but the rate changes over time. The bank adds a margin to a set index to get the new rate.
Most of the time, the index rate moves, but the margin stays the same over the life of the loan. For example, let’s say you have a mortgage with a variable rate and a 4% balance that is tied to the Treasury Index.
If the Treasury Index is 6%, the interest rate on a mortgage is the 6% index rate plus the 4% margin, or 10%.
What does “Trading on Margin” mean?
When you trade on margin, you borrow money from a brokerage company to make trades. When trading on margin, buyers first put up cash as collateral for the loan.
They then pay interest on the money they borrow on a regular basis. This loan gives buyers more money to buy securities, so they can buy more of them.
The securities bought automatically serve as collateral for the margin loan.
What’s a Margin Call?
A margin call is when a broker who gave an investor a margin loan asks that investor to put more assets in their margin account.
When an investor gets a margin call, they usually have to put more money into their account, sometimes by selling other stocks.
If the investor doesn’t want to do this, the broker has the right to sell the investor’s stocks to get the money they need.
Many investors are afraid of margin calls because they can force them to sell their stocks at bad prices.
Other Terms of the Word “Margin”?
The word “margin” is used in banking for other things besides “margin loans.” For example, it is used as a catch-all term for different types of profit margins, such as the gross profit margin, the pre-tax profit margin, and the net profit margin.
The word can also be used to talk about interest rates or risk fees.
Risks of Using Margin Trading?
When someone invests on margin, they risk losing more than what they put into the margin account.
This can happen if the value of the securities the investor owns goes down, forcing the investor to either pay more money or sell the securities.
Conclusion
Investors who want to make bigger gains or losses on trades may want to trade on margin.
Margin trading is when you borrow money, put up cash as collateral, and then use the borrowed money to make trades. By taking on debt and using leverage, margin can help investors make more money than they could have if they had only used their own money.
On the other hand, if the value of an investment goes down, an investor may end up owing more than what they put up as collateral.
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