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Margin trading tips for beginners

Guest Post | Jul 11, 2022

Margin trading - Margin trading tips for beginnersIf you just started your trading journey, you may have heard about margin trading, and wonder what it is and if it fits your investment profile. With this strategy, which is more sophisticated, there is more risk involved. Indeed, investors need to be cautious about this method. In this article, we will define key terminology like margin, leverage, and margin call and describe the potential risk and rewards.

Understanding collateral, leverage, and margin call

Essentially, margin is money borrowed from a broker to buy securities and financial assets. So, when you use this money to fund a leveraged position in the market, it is called margin trading.

In this scenario, there are some definitions that, as a trader, you must understand before starting using this strategy. One of them is collateral, which refers to a certain number of securities held in an investor’s account that will act as a guarantee for the loan. As expected, an investor has to pay interest on the money borrowed from the broker.

When operating with margin trading, an investor can put up less money than what would require for a spot position. This is possible because of leverage, which enables large and more diversified trades. Although it can lead to higher returns if the trade is profitable, it can also magnify losses if the operation fails. When the position goes in the wrong direction and losses add up, the broker will ask you to add funds to your account to maintain that losing position. This is what we know as a margin call.

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If the trader does not deposit the required funds after the broker’s warning and the position keeps losing, the broker may sell those financial securities with or without prior notice, resulting in liquidation. In addition, there is the possibility of losing more money than the initial invested amount. To avoid margin calls or liquidations, a trader should always look at its maintenance margin percentage, which depends on each broker but is usually in a range of 25-40%.

We can use some advanced strategies when doing margin trading in stocks, options, and futures. However, some of these tactics require approval from your brokerage and each one of them carries its own risk, so not all clients will qualify for them. Keep in mind that brokerages can set different rules, like minimum account balances, margins, and minimum maintenance amounts.

Find an example below of how this works. You buy $10.000 of stock A using $5.000 of your own and $5.000 that you borrowed from the broker. The broker sets a 25% maintenance margin.

Loss Scenario Profit Scenario
-        Stock A value falls and your bag goes from $10.000 to $6.000 decreasing your margin percentage to (6000 – 5000) / 6000 = 16.67%.

-        To get to the asked level you will need to add $500 as (1.500/6000) = 25%.

-        Stock A value increases and your position goes up to $14.000, so you sell and take profits.

-        $14.000 - $5.000 (that you return to the broker) - $5.000 (your initial investment) = $4.000 profit.

-        If you would not have used margin, a 40% increase on a $5.000 investment would result in only $1.600 profit

Key takeaways:

For traders and investors, margin can come in handy when potential opportunities arise. Margin can increase buying power and enable access to advanced trading strategies. Below are our tips:

  • Review your investment objectives
  • Do your own research, making an informed decision on whether you want to margin trade or not
  • Understand your risk tolerance
  • Find financial resources

Finally, one key topic that can, and will, affect all markets is the global macroeconomic situation. These fluctuations, produced by unexpected political, natural, and social events, would increase market volatility, increasing operation difficulty. In the following chart, you can see how balances in margin accounts have been decreasing since the start of this year's economic crisis.

FINRA CREDIT BALANCES IN MARGIN ACCOUNTS (184.15B USD for May 2022) [1]

Finra credit balances in margin accounts - Margin trading tips for beginners

[1] https://ycharts.com/indicators/finra_credit_balances_in_margin_accounts

 


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