Margin trading involves borrowing money from your broker to purchase securities. Margin trading involves using leverage.
Borrowing on margin enables investors to purchase more securities than they would ordinarily be able to buy than if they used just cash. When investments are bought on margin, the securities are used as collateral for the loan which has been taken out. The amount of funds which can be borrowed on margin is determined by the broker. If you want to engage in margin trading, you should, therefore, read the requirements set out by your broker very carefully.
How margin trading works
If the cash balance in your account is negative that means you owe money to your broker and the amount which you own attracts interest. If the balance is positive you may still be able to draw more money from your broker and may be able to borrow more.
Here is an example of how margin trading works in practice.
Tom has $100,000 in cash and takes out a $100,000 loan. He then buys $200,000 worth of shares. If each share is priced at $20 he can buy 10,000 shares. If after one year, the shares have now risen to $24, Tom's portfolio is now worth $240,000 a gain of 20%. Given that Tom only put in $100,000 of his own capital to buy the shares, the $40,000 rise in the value of his portfolio works out to be a 40% return on his capital. However, should the share price drop to $16, this works out to be a loss of $40,000. This would be a loss of 40% on his starting capital.
Had Tom simply purchased his shares using only equity, a twenty percent fluctuation up or downward in the price of the shares would simply lead to a gain or loss of $20,000 either way. Borrowing on margin heavily magnifies results to the upside or the downside. It should therefore only be used by investors who are extremely confident about the future of their investments. Misjudging the risk of an investment on margin can mean that all your capital can be lost.
