Trading on margin, also known as leveraging, refers to the practice of borrowing money to increase the overall investing amount a person has at their disposal.
Investing in the Stock Market using Margin
Trading on Margin Example
For example, Diana thinks she has a winning edge in the stock market, but she only has $20,000 to invest. She decides to request from her broker a margin account. The broker agrees and lends her $80,000 at a rate of 2% per month.
Diana now has $100,000 to invest. She is now leveraged 4 to 1. This means she has borrowed $4 for every $1 she owns.
This gives Diana the benefit of magnifying her profits. If she makes a 25% gain in her investments for the year, she will have made a total actual profit of $25,000. If she was only investing her original amount of $20,000, she would have only made a profit of $5,000.
The Problem with Trading On Margin
The problem with using margin is that if you do not manage your risk properly and you suffer a loss, the losses are also magnified.
For example, Diana has the same setup as before; she has 4 to 1 leverage on $20,000. Only this time, the stock market tanks (moves down quickly). She suddenly finds herself in a 20% loss for the year. Her telephone rings, she answers, it is here brokerage firm. They demand that she either injects more of her own capital into the account of they will close all the open trades and retrieve their money. This is known as a “Margin Call.”
In this situation, Diana made a loss of 20% but lost all of her $20,000. This means she was wiped out. If she had not used leverage, she would have invested $20,000 and suffered a 20% loss. Therefore she would still have $16,000 to invest with.
This strategy can magnify your gains
This strategy can quickly wipe out all of your capital
Very high – even professional investors and traders are very cautious about margin. This is not recommended unless you have a consistently winning low-risk strategy for the markets.