Margin trading is one of the choices you can choose when you open a brokerage account.
But before you start a brokerage account, you should know the accounts you’ll be choosing. Today we will talk about margin trading and the difference between a margin account and a cash account.
What is Margin Trading?
Margin trading refers to the practice of using borrowed money from a broker to trade a financial asset. This forms the collateral for the loan from the broker.
However, you should know that using financial leverage can possibly magnify gains but it could also saddle you as a trader with devastating losses. That is why leverage has a reputation of being a double-edged sword.
Because of the high risk of margin trading, it can only be conducted in a type of account, which is known as margin account. But we will dig deeper with this account later.
Margin, on the other hand, refers to the amount of funds that the investor or trader must personally put up from his or her own resources. Margin can vary widely depending on the asset or instrument.
For example, currency futures need a margin amounting to a low single-digit percentage of the currency value of the contract. A stock purchased on margin requires the trader to supply 30 to 50 percent of the value of the transaction.
As a rule of thumb, the greater the volatility of the stock, the higher the margin requirement will be.
Since margin trading is a risky business, it is governed by rules set by various entities. This includes the Federal Reserve Board, New York Stock Exchange and Financial Industry Regulatory Authority, and brokerage firms.
Opening a Margin Account
Meanwhile, to open a margin account your broker needs to obtain your signature. An initial deposit of at least $2,000 is required for a margin account, although there are some brokerages that require more. This deposit is known as the minimum margin.
Once the account is already open and operational, you can borrow up to 50 percent of the purchase price of a stock. The portion of the purchase price that you deposit is called the initial margin.
As a trader, you should know that you don’t have to margin all the way up to 50 percent. You can actually borrow less, like 10 percent or 25 percent.
Just beware that there are some brokerages that require you to deposit more than 50 percent of the purchase price.
With margin trading, you can keep your loan as long as you want provided you fulfill your obligations. First, when you sell the stock in a margin account, the profits will go to your broker against the repayment of the loan until it is completely paid. Second, there is a restriction called the maintenance margin, this is the minimum account balance you must maintain, before your broker forces you to deposit more funds to pay down your loan. Once this happens, it is called a margin call.
What is a Margin Account?
Now we’ll discuss the account that is used in margin trading. Margin account is a brokerage account in which the broker lends the trader or investor money to purchase securities.
The loan in the account is collateralized by the securities and money.
Because the trader is investing with the money of a broker instead of his or her own, the trader is using leverage to increase both gains and losses.
An example of margin account is when a trader with $2,500 in his or her margin accounts purchases Company A’s stock for $5 per share. With the $2,500 loan of the broker, the investor buys $5,000 of Company A’s stock and receives 1,000 shares. The stock appreciates $10 per share, and the trader makes $10,000.
Margin Account vs Cash Account
When you start a brokerage account, you must choose between two accounts: a margin account and a cash account. These two accounts have major differences, both positive and negative. That is why it is important as a trader to choose the most appropriate account to use.
As mentioned before, margin accounts allow the convenience of borrowing money from your broker.
However, with margin accounts, the securities you hold in your account can be lent out to short sellers. This is to generate additional income for the broker.
If this happens and the short sellers cover the dividend payment you’re authorized to receive, you won’t be able to claim the dividend as “qualified dividend” subject to much lower tax rates. Instead you must pay it with ordinary personal taxes. This may result into you paying double tax rate because your broker is trying to gain more profit for its own income statement at your expense.
In addition, you may be subject to rehypothecation or hyper-rehypothecation risk.
Cash accounts, on the other hand, do not allow any borrowing money from the broker or financial institution.
With cash accounts, any trades must be fully paid in cash on the required settlement date. This has the practical effect to place trades more frequently as there may not be available cash settled and ready to deploy within your account the moment you want to place a buy order.
Also, you have to wait until settlement to make a withdrawal of cash increased from a sell order.
Meanwhile, stocks held in a cash account are not loaned to short sellers. Without margin debt, traders holding securities within a cash account will not be subject to a margin call within the account.
In cash accounts, investors don’t have to worry about rehypothecation or hyper-rehypothecation risks.
Pros and Cons of Margin Trading
As an investor, you should know about some advantages and disadvantages that come with margin trading.
- Leverage Your Gains – When you buy shares on margin, it allows you to leverage your gains by enabling you to buy more shares on a cash-only basis.
- “Carry” Trades – This refers to borrowing at a lower interest rate and investing in an instrument that can make higher returns. For example, let’s assume that an investor with $50,000 to invest takes margin debt of $50,000. Then he or she invests the full amount in a diversified portfolio that yield 12 percent. So if the interest rate on the margin loan is 8.50 percent, the investor can generate an additional 3.50 percent on the overall portfolio.
- Diversify Your Portfolio – A margin account can be used to successfully diversify or hedge your portfolio. A good example of this is if you are too heavily concentrated in a few stocks or sectors. Your margin account can be used to add positions in other stocks or sectors to improve diversification. Meanwhile, if you already have a diversified portfolio and want to hedge downside risk, you can short sell the board market or specific sector.
- Take Advantage of Trading Opportunities – Trading shares on margin trading enables investors to take advantage of trading opportunities as they come.
- Interest Charges and Rate Risk – Margin accounts have a high rate of interest. The interest cost on margin debt can increase over time and erode gains made on margined securities. Take note that the interest rates on margin debt are not fixed but it can swing when an investor has a margin debt.
- Margin Call – The trader can face a margin call if the securities bought on margin sharply decline. If this happens, the investor needs to come up with a substantial amount of money at short notice.
- Extra Careful in Monitoring Account – With margin trading, a trader is required to be extra vigilant in monitoring the margin account or portfolio. This is to make sure that the margin won’t drop below the required level. This is stressful for an investor especially during the time of enhanced market volatility.
- Forced Liquidation – The brokerage can sell the margined securities without any notice if the investor can’t meet a margin call. Forced liquidation may result in the investor’s position being sold at the worst time and it can also generate a larger loss.
Choosing an account when you open a brokerage account may be difficult. Since you do not know which one will help you along the way. This is why it is important to know the meaning of the account, the differences of the accounts, and especially the pros and cons.
If you are an investor who is a risk taker, margin trading is for you. Meanwhile, if you are an average investor choosing cash account is better for you.
It is not wrong whether you choose cash account or margin account. As long as you know what you’re doing, the advantages and disadvantages, the consequences you might face along the way.
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