How does margin trading work? What are the pros and cons of buying shares using leverage? Read to get all the answers.
If you are new to stock trading, you have a lot to learn and one of the things that you need to know is margin trading of stocks. Newcomers and amateur stock investors are not recommended to start out with leveraged buying as it can be risky. In the following lines, we explain how it all works.
To put in simple words, when an investor borrows money from his stock trader to buy some stock, he is said to have bought it on margin. It is a loan granted by a broker to an investor for trading stocks that are marginally beyond his or her financial reach. This is a technique used to buy any kind of security, including stocks. It is leverage to boost your stock trading profits. Investors often resort to margin trading in a bullish stock market when they are sure that their liability will be easily paid off, once the price of the security rises.
When they make a profit, they pay back the loan amount and land up with a bigger profit margin, as their own principal investment is marginally lesser. An advantage of this type of trading is the way in which it substantially increases your buying power.
To start with this type of trading, an investor is required to open a separate margin account with a stock broker. The requirements of this account are different from a normal cash account. There is a certain minimum amount that you need to pay before you start using it. Also, you need to maintain a minimum balance, decided by the broker, if you want to continue using this account.
As a general rule, you can borrow funds that are 50% of the price of stocks that you are planning to buy. Interest is charged on the borrowed amount, until you repay the loan. When you make a successful sale and gain profits, the broker takes his share out of it until you have fully repaid your loan. Also, the securities you buy are used as collateral for your loan.
The equity value is the valuation of your stock holding, according to current market prices. If it so happens that the value of your equity falls, you need to deposit cash or other securities in your margin account to maintain the debt-to-equity ratio.
There is an important regulatory measure that you need to know, if you are considering buying securities on margin. As a general rule, the investor needs to see to it that the debt to personal equity value ratio in the margin account, is maintained to be 50% or lesser. That means, if I hold equity worth USD 30,000, then I can only borrow a loan up to or less than USD 15,000.
Borrowed sum, as a leverage, can be used to maximize the profit, but, if the invested stock fails to perform, you may land up with heavy debt. In case of a dip in debt-to-equity ratio, you might get a call from the broker to pay up, which is called a margin call. Though risk is inherent in stock trading, it is higher when you are buying on margin. It is not a recommended course of action for beginner investors.
Which Stocks Cannot be Bought This Way?
Not all stocks can be bought using a margin account. The stock exchange regulatory board doesn't let you buy securities like Initial Public Offerings (IPOs), penny stocks, and over-the-counter bulletin board securities on margin. This is a measure enforced by the regulatory commission to reduce day-to-day trading risks. Other than that, a broker may decide to restrict your stock choice. When opening a margin account, read all the terms and conditions carefully and note the interest rates charged on your loans.
It is risky business, as you may end up in serious debt if your stock does not perform as well as expected. Only experienced and seasoned investors, who have enough ballast to steady their ship in case of hitting rough waters, can go for margin trading. I feel that it's always a better strategy to bet out of your own pocket. This strategy will stand you in good stead in the long run. If you must take the risk, make sure that it is a calculated one and you know what you are doing.