Margin Trading is risky but can have Big Rewards
Sep 28 '00
Trading on Margins has two very distinctly different possible outcomes. One is good while the other is less than good, and at times can be horribly bad. Not only can margin trading yield extreme elation and major depression in those using margins to run their accounts, there are several things to know before diving into margin trading. First lets talk about the risks and rewards and then I can explain some of what to expect in terms of requirements when trading on margin.
Risks and Rewards:
Ok, you ask; "what is in it for me?" If you play your cards well, you may find a bigger return on investment. Translated this means more money for you and of course for the IRS at tax time. When trading on margin you effectively are borrowing money to purchase part of the stock you hold. Thus, if that stock goes from $18 to $40, you gain $22 per share for all of the stock owned. When you pay off the "loan" for the shares purchased on margin, you get to keep the $22 per share on those shares less your trading and margin costs.
If you could only afford 100 shares at $18 without margin but with margin you got 200 shares. When it is all said and done you get to take as a return on investment $22 * 200 shares = $4,400 less your trading expenses. I will not quantify them because there are many factors that play in here. Your margin costs as well as commissions vary by broker and based on where your account falls in the scheme of priorities with the broker. Some folks get better rates than others (another review in itself.)
Ok, you say; "that sounds great, sign me up." Well, lets look at the downside. In face lets look at the same stock but at a different point in time. Instead of buying at $18 you bought at $40 because you thought heck if it made such a good return over the last few weeks the great return must keep on trucking ahead. You buy the same 200 shares at $40 and pay $4,000 yourself and "borrow" $4,000 which is the margin. The next day, bad news comes out and your stock is not down to $20 before you can sell it. Ouch, that is a bad sting. Your stock is now worth $4,000 in total and your equity is effectively 0% of the position. Remember when you bought the stock with a 50% margin but your equity went poof and you are now at 0%. Guess, what, you just lost it all and will be responsible for any expenses incurred by the Broker to liquidate the position in the stock. Thus, you could owe even more money than you initially invested. You are now out all of your money and still have a bill to pay for brokerage and margin services.
Other Factors to Consider
Before you can open a margin account at most brokerage houses, you are required to complete more information about your trading experience. If you are a new trader it is unlikely that you can open a margin account, or if you can you will be only allowed a small percentage of a position on margin. The exact rules vary from broker to broker, so call yours to learn more.
There are costs associated with margin accounts. "Borrowing" the money to beef up your position in a particular stock does have a cost. Each brokerage house has different rates for the money they "loan" out for margin traders. These costs are in addition to the costs of making the trades. Thus, when figuring a profit on a stock one must also consider these costs.
You give up some control over your account when trading on margin. As part of the package, trading on margin carries with it the responsibility that you maintain at least a certain level of equity in your account. Unlike with your primary residence, most companies will not allow 0% down or even 5% down. Your equity, which depends upon so many different factors such as your trading activity, experience, relationship with the broker, and your overall account value, will usually have to be at least 25% and often times at 50% or higher. When your equity falls below those minimums, the broker has the right to liquidate positions that will bring your equity in the account back above the minimums. At the same time you are responsible for all costs associated with these liquidations. If the entire account is liquidated, you may be billed for any deficit created by the margin. That adds insult to injury if you just lost all of your investment money.
Closing Thoughts
Not everyone will be allowed by every brokerage to trade on margin. Call your broker to discuss your specific position. Make sure you know what will happen with a stock you buy on margin. Keep well within the margin limits to prevent margin calls where you are forced to increase your equity. Enjoy your trading but trade cautiously and sensibly. It is ultimately your money you are playing, or gambling, on these stocks.
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