Margin trading refers to the process of buying more stock than an investor is normally able to afford. This is done by borrowing money from your stockbroker in order to purchase stocks. In return, you pay the broker an annual interest for the amount you borrowed. This article goes through how to get into margin trading, what to look out for, and some on-point margin trading tips for the next year.
How do You Get Into Margin Trading?
For a trader to be able to buy on the margins, they would need to open a margin account. Note that you are required to pay a certain amount up front for the purpose of helping your broker recover some money, especially in the event that you lose the bet and fail to return the borrowed funds. This is called your minimum margin. Once the account is opened, you’ll need to pay the initial margin, which is a percentage of the purchase price of a stock.
Buying on the margins is a decent method for traders to leverage their gains, especially if you don’t have a lot of capital to begin with. To illustrate:
You can buy $20,000 worth of securities from $10,000 borrowed money and $10,000 from your own cash. If the value of these securities increases to $25,000 and the amount of money you borrowed stays the same, your equity becomes $15,000 — a much better outcome than if you had started out with just your own capital.
What to Look Out For
However, margin trading also comes with steep risks.
The Balance provides a detailed explanation on why margin trading would not be a good idea for inexperienced traders. The article points out that investors could lose everything by buying more shares, especially if the company they invested in goes bankrupt. You can also fall into the trap of rehypothecation or the practice among brokers of using client assets posted as collateral for their own purposes.
While margin trading usually refers to stocks, it can also be applied in forex trading. The process is quite similar to margin trading in stocks. FXCM gave an overview of trading on the margins with forex, explaining that it involves setting aside the required margin for your trade size. When you trade in forex, you’re essentially borrowing the first currency in the pair so that you can buy or sell the second currency. And just like margin trading with stocks, it also comes with a set of risks and rewards.
Investors also have the option to buy on the margins for cryptocurrencies. However, this entails even more risks than the previous two, given that cryptocurrencies are highly volatile. But the process, overall, is similar: it requires borrowing capital at high interest rates from a cryptocurrency exchange so that you can access increased leverage.
Margin Trading Tips for 2018 & 2019
That said, if you still want to try your hand at margin trading, here are some margin trading tips you can follow to help reduce the chances of getting negative results.
1. Check the Interest Rates
The annual interest rate that a stockbroker charges will depend on the size of your portfolio. So before you enter margin trading, you need to understand the exact rate you need to pay. This can help you work around your costs and avoid any surprises, thereby increasing the chances of success.
2. Don’t Buy All in One Shot
It’s not a wise strategy to buy your positions all in one go. After all, you don’t want to put all your eggs in one basket. If you want to reduce the risks of losses, it’s better to take on a gradual approach. You can buy 50% of the position on your first shot, then add money to your account if the value rises by a certain percentage. If your stocks fail, at least you won’t have to suffer huge losses.
3. Avoid Margin Calls
A margin call is a warning given by your stockbroker if your margin level reaches dangerous levels. When you receive such an alert, you either need to add more money to your accountorsell your stocks to compensate. However, you should first make sure you have enough funds in your account and choose a trusted broker for these deals to begin with.
4. Take Advantage of Stop-Loss Orders
Stop loss orders are another way to prevent margin calls. Stop loss orders function like an insurance buffer and, in effect, help you stop your losses. Through a stop loss order, an investor’s position will be automatically sold if the trade goes sour or if the stock or currency goes below a certain value. There are two types of stop-loss orders: namely, stop market orders and stop limit orders. The former will sell shares allotted at the market price once the order is activated, while the latter will place a limit order when the set price is hit. Stop loss orders are also great for removing market emotions and promoting disciplined investing.
5. Stick to Your Strategy
In line with the previous tip, discipline is crucial in investing. Don’t try to speculate with either your own or borrowed money, because it usually ends in losses. Use margin trading in conjunction with a profit and loss ratio and invest in a disciplined manner. It’s usually best to tune out the suggestions or calls from third parties and just stick with your plan from start to finish.
6. Be Wary of Upcoming Events
Events like earnings reports and general meetings should generally be on your radar, but you’ll need to pay special attention to these if you have margin funds. Traders usually buy additional stock on margin if they anticipate positive results from these events. But of course, you should also have a backup plan in case the news doesn’t go in your favor.