Margin trading, or buying on margin, means offering collateral, usually with your broker, to borrow funds to purchase securities.
This practice allows investors to obtain greater exposure to more securities than they could own otherwise with cash only. An investor will, however, need to open a margin account with a broker first, in order to conduct margin trading.
Example of buying on margin
The broker will assess an investor regarding his creditworthiness and risk. After an assessment, the broker will set an “initial margin” requirement and a “maintenance margin.”
The initial margin will differ depending on the instrument traded. If the broker sets an initial margin of 50% for one lot position @$100 AAPL, then the investor needs 50% times $100 per share times 100 shares per lot, or a margin of $5000 on his portfolio to purchase one standard lot position. Alternatively, he may place $5000 worth of collateral with the broker to guarantee this margin.
The maintenance margin is like a debt covenant for leveraged firms. It is the total margin needed to maintain opened positions. If a broker sets this margin to 30%, for example, on an account valued at $10,000, then the investor must maintain at least $3,000 in margins. If the value of the investor’s open trading positions falls below this maintenance margin required amount, then the broker will initiate a “margin call’, which requires the investor to either deposit more funds or liquidate some of his or her open trading positions, to comply with the margin requirement.
Benefits and risks of margin buying
The main benefit of margin trading is maximizing potential profit through the leverage provided by margin trading. In essence, the practice allows investors to increase their portfolio beyond the size of their real available funds.
The biggest risk, however, is the possibility of substantial – even potentially ruinous – losses through forced liquidation. If, for example, an investor buys heavily into a stock that they feel confident is going higher, just a temporary downside retracement in the stock’s price might trigger a margin call that ultimately results in the investor being forced to liquidate his position at a loss. If the stock then moves higher as the investor expected, he or she may not have enough trading capital left to take advantage of the uptrend. The higher the leverage provided with margin trading, the higher the potential profitable return – but also the higher the risks.