One of the givens of the stock market is the consistent, never-ending risk that it poses to traders, no matter how good they are. In fact, it has been seen and accepted by many as an occupational hazard. This is because it is normal to take on a certain degree of risk to get into a rewarding position. However, margin trading takes risk to a whole new level. Sure it is risky for you to stump up a huge sum of money to place on an uncertain trade, but coughing up a sum and borrowing more to put it all into trades is interstellar-level risky. Makes one wonder to what extent the risks truly go and what benefits are enough to make traders take those risks.
What are Margin and Margin Trading?
Margin trading, eponymously so, involves using a trading feature called a margin to amplify the size of a trade. This is done by borrowing extra funds to execute a trade for profit, after which they are returned in full to the brokerage. The trader creates a margin account, funds it with his initial capital, and increases it by several times its original size through leverage. All this might sound a bit complicated, so let us break it down further. Stephanie is a stock trader interested in trading a particular asset with $2000 but has only $1000 for it. She approaches Jake, a broker with a large number of assets to his credit, for help. Jake tells her to put down the $1000 with him and go ahead to take $2000 from his portfolio. She does, makes the trade, and accrues a profit of $200. She returns the $2000 to Jake with some interest, recovers her $1000, and keeps the rest of her profit. This is the entire process of margin trading. It works much like a conventional loan, with aspects such as collateral and interest. The initial $1000 would have been used to offset the debt if the trade had recorded a loss. The initial deposit Stephanie made that was held in collateral by Jake is the margin. Margin and the overall concept behind margin trading exist in other forms, such as futures trading. However, variations such as available leverage and risk set them far apart.
Benefits of Margin Trading
- Maximum Investment Returns: Margin trading is an incredibly convenient way for you to amplify how much you can make for a trade. The more risk an investment carries, the greater its rewards. Margin trading allows you to take even more risk and access higher rewards for your trading ventures. In the scenario above, Stephanie made a 10% profit on her trade. If she had gone with her initial $1000, she would have made a profit of $100. That is still pretty sweet, but not as much as $200.
- Trading Confidence: This might not seem like much, but it is a big deal. There are some trades in which you would spot the potential, but the size of your portfolio might intimidate you into backing out. Fear no more, as margin trading has you covered. It is a viable avenue for you to go into the big trades despite not having enough to make you comfortably execute them. It also allows you to conveniently invest in multiple trades and assets simultaneously with techniques such as dollar cost averaging and hedging. This increases your overall confidence in your portfolio and your chances of success.
- Stability: Margin trading is spot-based, despite looking like a derivative form of trading due to its use of leverage. Thus it is a true rarity to offer leveraged trading in the spot market. This means margin buy and sell orders are matched with the spot market’s, making it a beneficiary of the market’s liquidity and subsequent stability.
Risks of Margin Trading
- Potential for Unlimited Losses: This is perhaps the most significant risk of margin-based trading. It opens you up to losing a lot more than you initially put in, as you are likely trading several times your initial deposit. If your trade goes south, you have to account for your own deposit’s losses and the funds you borrowed from the brokerage. This is how your losses are amplified the same way your profits would have been. It may be harsh, but it is only fair to the broker.
- Liquidation: Liquidation in margin trading is one of the most important factors to take note of. It is the right of the brokerage to terminate your trade and take possession of your margin. This is done when they feel that your trade has lost so much that you are at the risk of not being able to pay the borrowed funds at the end of the trade. Thus, they take all your margin and use it to minimize their own losses.
There you have it. Margin trading is a very real concept, and that is because it is not too good to be true. It possesses risks, risks proportionate to the mouth-watering rewards it offers. Having grasped a full understanding of these risks in comparison to the rewards, it is left to you to know whether it is worth taking up.