How do Wall Street traders make millions of dollars? Well, there are many reasons but one of the most common reason is something known as margin. This is one of the most misunderstood terms in the financial market. An item that has made so many people lose money. In this article, we will look at what it is and how margin trading works.
What is Margin Trading?
Margin trading is a term that is a concept that allows traders to invest using borrowed money. The best way to explain margin trading is to use an example. Assume that you had $10,000 and you want to invest in Amazon stock that is trading at $1,800. In this situation, you can use your $10,000 to buy 5.5 shares. As such, if the price reaches $2,000, your account will reach $11,000. Your profit will be $1,000.
Alternatively, you can go to a bank and borrow another $10,000 and invest in the stock. In this case, you will buy 11 shares. If the stock price rises to $2,000, you will make $22,000. If you return the $10,000 to the lender, you will have a profit of $2,000.
This is a good example of how margin trading works. The loan that you take is known as a margin loan and is offered by most brokers. You can use margin to trade stocks, ETFs, bonds, and commodities. You cannot use it to buy CDs and money market funds.
How Margin Trading Works
Margin trading is a very common method that is used by many Wall Street traders. Retail traders too use the strategy to maximize their returns. The process works in a very simple way.
First, you need to select a broker that offers margin trading accounts. Internationally, many forex and CFD brokers offer this type of trading. In recent years, these companies have been forced by the European Securities Market Authority (ESMA) to lower the margin that they can offer to traders. The maximum leverage in the European Union is 30:1. This means that if you have a $10,000 account, the maximum amount you can use to trade is $300,000.
Margins are highly regulated in the United States. We will look at the reason for this below. The Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) have developed a number of regulations related to margin. For example, FINRA requires that you can only use margin if you have a minimum amount of $2,000. The minimum amount increases for a person who is classified as a “pattern day trader.” In this case, the amount increases to $25,000.
This amount is known as the minimum margin. Another margin regulation is known as Regulation T of the Fed. This states that you may borrow up to 50% of the purchase price of equity securities. This amount of money is known as initial margin.
The rules of margin trading do not end there. According to FINRA, you need to have a maintenance requirement. This means that you must have some money set aside after you open a trade. This amount should be at least 25% of the total securities you have purchased on margin.
The best way to explain this is to use an example. You buy $20,000 worth of stocks by borrowing $10,000. If the stock declines to $14,000, the equity in your account will be $7000. As such, if the firm has a maintenance requirement of 25%, it means that the trade will be stopped when the price reaches $4,0000.
Online Brokers that Accept Margin Trading in the USA
There are many brokers in the United States. Not all of them allow you to margin trade. Here are the best traders to margin trade in the United States.
There are several things that you need to remember when selecting a good online broker. First, look at the commissions that they charge. These days, Robinhood has forced all US brokers to drop commissions. Second, you need to look at the terms of margin trading. This is important because brokers have different terms for margin accounts. Third, you need to look at the user interface of the company.
Disadvantages of Using Margin Trading
As shown on the example above, it is possible to make some good money when using a margin. However, margin trading is also risky, which is the main reason why regulators have made it a bit difficult. Here are the main risks of using margin trading:
- More losses – Margin trading can make losses more. In the example given above, if the stock moved lower, you would lose more money.
- Losses bigger than equity – With margin, it is possible for you to lose more money than you have in your account.
- Forced liquidation – You may be forced to sell some or all of your open securities when the falling stock prices reduce the value of your stocks.
- Broker action – The brokerage may sell some of your open positions without notifying you. Also, the broker may increase its margin requirements at any time.
- Time factor – The broker will close the trade automatically and you will not be given an extension.
Summary of Margin Trading
In short, margin trading is a good way to maximize your returns in the market. However, it is also a risky method of making money. You can protect yourself by reading the terms and conditions before you start trading. Also, you need to understand the interest rate your broker charges you to borrow the margin. Also, you need to understand that not all assets can be traded on margin.
Crispus is a finance professional with more than a decade experience in the industry. Over the years, Crispus has written in-depth articles on leading platforms like CCN, Marketwatch, and Seeking Alpha. He also runs a Forex education and managed account company called WestEndFx.