What is margin trading? It's buying stocks with someone else's money. When done skillfully, it can multiply your returns. But this type of leveraged investing also has big risks.
XThe definition of margin trading is straightforward. Trading on margin is when you borrow funds from your broker to buy more shares than you would with your own cash. The shares you purchase act as collateral for the loan.
You could spend, say, $2,500 to buy 50 shares of a stock quoted at 50 per share at its breakout and buy another 50 shares with $2,500 borrowed. A 10% gain on $2,500 is $250. Coupled with $2,500 on margin, the profit doubles to $500.
What's not to like? Well, with any leveraged investment, losses can multiply quickly. What if the stock you bought at 50 a share falls to 40? The value of the trade is reduced to $2,000 on the shares bought with cash, but it plunges from $5,000 to $4,000 with the shares purchased on margin. You're down $1,000, and you still have to pay back that $2,500 you borrowed.
If losses are steep, you could lose more than you invested.
What Is Margin Investing? Investors May Be Surprised
"Some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin — without any notification and potentially at a substantial loss to the investor," the Securities & Exchange Commission warns. "If your broker sells your stock after the price has plummeted, then you've lost out on the chance to recoup your losses if the market bounces back."
Facing such high risk, investors must be ready to cut losses short when stocks fall in price. If the stock market starts to deteriorate, it is imperative to sell quickly and get off margin.
"You must understand that when the general market declines and your stocks start sinking, you will lose your initial capital twice as fast if you're fully margined than you would if you were invested on a cash basis," IBD founder William O'Neil wrote in "How to Make Money in Stocks."
What Happens When You Get A Margin Call?
If declines in your margin trading account grow heavy, the brokerage may demand that you put more money into the account to cover losses, or ask you to sell holdings. That's a margin call, and you are better off selling shares rather than adding money.
If you get a margin call, "The marketplace is telling you that you're on the wrong path, you're getting hurt, and things aren't working," O'Neil wrote. "So, sell and cut back your risk level."
What Are Margin Requirements?
Investors need to set up a margin account with their brokerage, and there will be interest to pay on the borrowed funds, just like with any loan. Keep in mind, some stocks are not available on margin.
The Financial Industry Regulatory Authority, or FINRA, says investors must deposit $2,000 or the full cost of a margin purchase, whichever is less, before executing a stock trade. In some cases, it could be more. Generally, you can borrow up to 50% of the total purchase price for new trades.
Accounts also must have minimum 25% equity, which is the percentage of the market value of securities from the amount borrowed. This "maintenance requirement" is higher at some brokerages, sometimes 30% to 40%, the SEC says.
This article was originally published Sept. 10, 2019. Juan Carlos Arancibia is the markets editor of IBD and oversees market coverage. Follow him on X/Twitter at @IBD_jarancibia
YOU MIGHT ALSO LIKE:
Get Free IBD Newsletters: Market Prep | Tech Report | How To Invest
When Is A Double-Bottom Base Something Else? Knowing Determines When To Buy
Get Notifications For Live IBD Videos By Subscribing On YouTube
How Much Money Do You Need To Start Investing?
See IBD Stock Lists & Get Pass/Fail Ratings For All Your Stocks With IBD Digital
