Macro Mondays: Margin Trading
Welcome to yet another edition of Macro Mondays! The parallels between investing and gambling are quite evident, but they become blatantly obvious when you take a look at margin trading. If you visit a casino, are you allowed to borrow money from the casino to bet? This might sound silly, but it isn't when it comes to margin trading - you can effectively borrow extra money to make trades that you otherwise wouldn't be able to make.
Great if you make money, very bad if you lose money.
What is 'Margin Trading'?
As we alluded to earlier, let's continue the casino analogy. Imagine this: you're sitting at the blackjack table and the dealer throws you an ace. You'd love to increase your bet, but you're a little short on cash. Luckily, your friend offers to spot you $50 and says you can pay him back later. Tempting, isn't it? If the cards are dealt right, you can win big and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you be down your original bet, but you'll still owe your friend $50. Borrowing money at the casino is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.
Investing on margin isn't necessarily gambling. But you can draw some parallels between margin trading and the casino. Margin is a high-risk strategy that can yield a huge profit if executed correctly. The dark side of margin is that you can lose your shirt and any other assets you're wearing.
One of the only things riskier than investing on margin is investing on margin without understanding what you're doing.
What are the Basics to Buying and Trading on Margin?
Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally.
To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. By law, your broker is required to obtain your signature to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin. Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It's essential to know that you don't have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price. 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 proceeds go to your broker against the repayment of the loan until it is fully paid.
Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a margin call.
Borrowing money isn't without its costs. Regrettably, marginable securities in the account are collateral. You'll also have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on. Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you. Not all stocks qualify to be bought on margin.
How is margin trading regulated?
The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers will not allow customers to purchase penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the day-to-day risks involved with these types of stocks. Individual brokerages can also decide not to margin certain stocks, so check with them to see what restrictions exist if YOU have a margin account.