So you want to buy financial instruments worth more than your personal capital? Margin trading is the right choice. But the benefits, risks, and features of margin trading can be a bit challenging to grasp.
Follow this beginner-friendly guide to understand the ins and outs of margin trading:
What is Margin?
Margin is essentially a tool traders use to increase their purchasing power. Traders borrow funds from a broker to acquire a position much higher than they could afford with cash alone.
Margin, itself, is the collateral that a trader deposits with the broker to borrow funds. This is used to cover any potential losses that might be incurred during financial activities.
How Does Margin Trading Work?
Margin trading, also known as leveraged trading, is the process of opening a financial position using a deposit (called margin), while the broker covers the rest of the cost. Brokers have varying margin rates – the percentage of money you need to place a trade.
Look at it this way: If you want to buy 10 shares in a company valued at $100 each, you’d have to pay $1,000 upfront to gain exposure. But if you go with margin trading with a fixed rate of 20%, you’d only need to pay $200, and the broker will cover the rest.
With margin trading, you need to pay an initial margin as a deposit. This acts as your safety net and collateral. Traders can also use their existing securities as collateral, getting additional funding from the same broker.
Benefits of Margin Trading
Margin trading offers several benefits, such as:
Increased buying power
This is pretty obvious. Margin trading can increase your borrowing power, allowing you to open larger positions.
Amplified returns
With larger positions, the chances of high returns would increase. If your investment is successful, you will earn amplified gains, especially when you compare them to your initial capital.
Portfolio diversification
Margin trading allows you to gain exposure to numerous financial markets, including stocks, indices, and even Forex. The result? A diversified portfolio, resistant to sudden market fluctuations and political unrest.
Risks of Margin Trading
Since you’re borrowing money from a broker to open positions, margin trading comes with some risks. Here’s a closer look:
Increased loss
Leverage is a double-edged sword. If margin trading can amplify your profits, it can increase risks compared to normal investing. Even a tiny price depreciation can put your entire account at risk. You could lose more than your deposit if you don’t take steps to manage risk.
Cost of maintenance margin
If a position moves against you, your broker might ask you to pay an additional amount, called maintenance margin. This can be an added financial burden for traders already dealing with costs.
Account fees
Many brokers charge extra for opening a margin account. You would have to pay additional account fees and even interest charges.
Despite the risks, margin trading is an excellent opportunity for traders to increase their borrowing power.