Ever wanted to trades stocks using margin but not sure how it works? This article will give you an overview of the requirements for a margin trading account. What you will not find here is margin trading strategies; I will discuss that in a later post. Margin trading is not for everyone and you should consider the risks associated with it as they can be double that of cash trading.
What is Margin?
The easiest way to explain margin is a loan from your broker. If you are going long or buying a stock, you can use margin to purchase more shares than your cash balance can afford, thus using a loan from your broker to purchase the stocks. If you are shorting or selling a stock that you don’t currently own, your broker will loan you the stocks to sell. You pay the loan back when you sell the stock (if you were long) or give the shares back when you purchase (if you were short) the stock plus the interest accrued.
Margin Account Requirements
All brokers require at least $2,000 account value to apply for margin trading and at least $2,000 to use margin. Each broker has different limits but these are the minimums set forth by the SEC (Securities Exchange Commission.)
Initial Margin is the amount of cash that you put towards the purchase or sell of a stock.
Maintenance Margin is the value the account must maintain before getting a margin call. Margin calls can happen without your brokerage firm ever notifying you. So, it is important that you know what the maintenance margin is. This changes with brokerages and is at least 25%.
Margin Call is when your account dips below the maintenance margin and the brokerage either notifies you to sell positions to cover your margin or the broker will liquidate your account in order to meet maintenance.
Now that you got the informal definitions here is an example:
Your have $5,000 cash in an account. XYZ company’s shares are selling for $100.00 per share. You want to buy as much as possible because you think the stock is going to move. A cash only account would allow you to buy 50 shares of XYZ but you have margin and can now afford 100 shares. You use margin and buy 100 shares and owe your broker $5,000 which is payable on the sale of XYZ stock.
Outcome # 1
XYZ company’s stock goes up the next day to $120.00 and you decide to sell all 100 shares for $120 a share. You receive $12,000, the broker takes back the $5,000 and you profit $2,000 minus interest. With cash only, you would have only profited $1,000. So by using margin you doubled your gains.
Outcome #2
This is probably the most important outcome that you should know so get it stuck in your head. If you use margin, remember this outcome and use stop loss orders.
Again, you think XYZ company is headed higher and decide to purchase 100 shares at $100.00 using margin. So you put your initial margin of $5,000 up and use margin for the rest. The next day, shares of XYZ fall 50%. If you sell now at $50 per share, you will receive $5,000 which will go directly to your broker to pay back the margin loan. This brings your account to a zero balance and you still owe interest, so you decide to hold on for one more day and hope that XYZ moves up so you can get out at least at break even. More bad news for XYZ and the shares drop to $25 a share, and you receive the dreaded margin call. Your broker informs you that he has sold all 100 of your shares at $25 for a total of $2,500 and states that you must deposit $2,500 into the account, plus interest, just to bring the account back to zero. Yeah, you lost $7,500 plus interest when you started with only $5,000; losing borrowed money isn’t fun.
Many people say that using margin is like taking a loan and going to Las Vegas. If you use margin, please use stop loss orders and only use margin for short term trades or interest will eat away at profit.
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