The most popular way to purchase stock is by transferring money from your bank account to a brokerage account and then using that money to purchase stocks, mutual funds, or other securities. But that’s not the only way.
Also referred to as buying a margin, margin trading is a scenario where a trader borrows money from a brokerage company and uses the money to purchase stock. In other words, margin trading is where you borrow cash from your broker to buy stock and repay it back with some interest.
While margin trading appears attractive to many investors due to the potential of higher returns, it is also important to understand the risks that come with it. Buying on a margin is a type of leverage used by investors who want to magnify their returns. This means that if things don’t go as expected, an investor can experience losses as well.
Let’s assume an investor would like to buy 200 shares in a company that’s apparently going for $30 per share. But the problem is that the investor only has $3,000 in his brokerage account. He opts to buy 100 shares and approaches his brokerage firm to borrow $3,000 in order to purchase the other 100 shares.
By trading the shares, the investor can either double his investment or lose his money. This will all depend on how the price of the shares bought will shift.
From the above example, it is evident that margin trading can both be lucrative and risky at the same time. It is therefore important for investors to understand all the risks involved before getting started with margin trading. Here are some of the important components of the loan:
•Similar to a secured loan, the brokerage firm will require that you give collateral that will serve as a security deposit. This includes the value of all the assets held in the investor’s account. The minimum amount required by most brokers is $2,000.
•Credit limit – The amount you are allowed to borrow depends on the price of the asset you want to purchase as well as the value of the collateral.
•Just like any other loan, investors are charged interest.
There are several advantages that come with margin trading. They include the following:
1.It amplifies your profits – margin trading gives you an opportunity to increase your profits by borrowing extra money from a broker to buy extra shares.
2.It increases your purchasing power: Margin trading allows you to borrow money and buy more stock.
3.Diversification: Buying on a margin generally gives you an opportunity to diversify and reduce the risk of losing a lot of money.
There are several benefits of a margin account. Although buying on a margin comes with a certain level of risks, investors stand to benefit a lot. As per the experts at SoFi, “While margin accounts do come with risk—including the risk of losing more money than you originally had, plus interest on what you borrowed—they also offer benefits including more purchasing power and a safety net for short-term cash needs.” With a margin account, you have a chance to borrow as much as you want to buy stock and maximize your profits.