Online trading market has a huge spectrum. It allows you to trade in a variety of ways. Marginal trading is one of those options. Marginal trading lets you borrow money from the brokerage to facilitate your investments. Stay with us and by the end of this blog you will be aware of the basics of marginal trading. Marginal trading holds apparent risks and one has to be aware of it. We will help you to understand the probable merits and demerits of marginal trading.
WHAT IS MARGINAL TRADING?
For buying a stock the traders either deposit the required cash into the brokerage account or they collect the money from dividends or interests from the assets they own. But there is a third way as well. They can borrow money from the brokerage and this is known as margin trading. To put it simply, via marginal trading the brokerage lends you money to buy stocks. This money is solely to enhance your purchasing power for the stocks. The money is borrowed at a relatively low rate. Other securities and assets in your brokerage account are kept as the collateral for the money borrowed.
HOW DOES MARGINAL TRADING WORKS?
The very first step is to open a margin account about which we will talk later. Once you open a margin account you have to deposit a certain amount that is known as minimum margin. The value of minimum margin may differ as per the brokerages. The investor also has to maintain the maintenance amount of the margin account whose value is also decided by the brokerage.
Let us understand this with an example. Suppose you wish to purchase 100 stocks of company ‘X’ with a worth of $10 per stock. This requires an investment of $1000. Now let’s say you wish to do it with marginal trading. After you successfully open the margin account the brokerage will ask you to pay 50% of the stock price as minimum margin and 20% as maintenance margin. That means you need to pay $500 at the minimum and the rest you can borrow from the brokerage. Now suppose your stock met with a downfall and the equity reached below maintenance amount. Under this circumstance you will receive a margin call to cover the maintenance amount. If you are not able to do so in due time then the brokerage is free to sell the stocks kept as collateral to recover the borrowed amount.
HOW TO OPEN A MARGIN ACCOUNT?
A margin account is different from a standard brokerage account. To open a margin account is quite easy. Sometimes the option of margin account is already present in the normal brokerage agreement but sometimes they provide you with a separate agreement. Once you are ready with the minimum margin all you have to do is fill up a form and wait for the approval. Once approved you are all set to go.
HOW MARGIN ACCOUNT IS DIFFERENT FROM CASH ACCOUNT?
A standard brokerage account or cash account lets you deposit cash. Via this account you can only purchase those stocks whose price can be paid by the cash present in the account. There is no provision of loan here. Whereas in a margin account you are allowed to borrow money up to 50% of the price of the stock.
PROS AND CONS OF MARGINAL TRADING
There are many traders in the stock market that have amazing strategies and can make lots of money via online trading. But lack of investment becomes an obstacle for them. Margin trading helps them to overcome that obstacle. It also increases the buying power of an investor which ultimately results in building a good stock portfolio.
However marginal trading can be very risky. The fluctuation in stock prices is uncontrollable and can bring about a huge loss. In that case the brokerage is free to sell the stocks and other securities that have been held under collateral.
10 THINGS YOU NEED TO KNOW ABOUT MARGINAL TRADING
To sum up the entire theory and procedure of marginal trading I have summarized it in the following 10 points:
- Marginal trading allows the investors to borrow money from the brokerage at low rates in order to purchase some stocks.
- The stocks and other securities available in the investor’s portfolio are kept as the collateral.
- Margin allows the investors to borrow up to 50% of the amount of the stock they wish to purchase.
- The amount borrowed is kept in the margin account which is different from the cash account.
- Maintenance amount and minimum margin are the two basic requirements that have to be met to open a margin account.
- Maintenance amount is the minimum amount that has to be maintained in the margin account. The value of this is set by the brokerage. If the investor suffers loss in the trading of that particular stock and the value in the margin account goes below the maintenance amount then the investor will receive a margin call.
- This call means that the investor has to refill the maintenance amount within a specific time duration. If not, then the brokerage is free to sell the collateral and recover the loan.
- Minimum margin is also set by the brokerage. It refers to the amount that has to be paid by the investor, other than the loan, to purchase a stock.
- When the brokerage sells the collateral he only takes the money worth the loan and interest. Rest of the amount of the trade goes to the investors account.
- Marginal trading increases the purchasing power of an investor. If the price of the stock goes down it can result in severe loss to the investor.
It is true that marginal trading can amplify the performance of the investor. By increasing the buying capital the traders can invest more than their pocket. But this scenario can be severely damaging if things didn’t go as predicted. So it is better to use marginal trading for short term trading goals.