Buying on Margin: Know More Tips, Benefits, and Risks
Buying on margin is one of the most sought-after strategies in the trading world. We know you’ve heard a lot about it and you’re excited to try it out.
However, we also know that you want to know what you’re signing up for. Remember that like all strategies, buying on margin can also be dangerous. The risks are just as many as the benefits you can get. So you must make sure that you really know what’s going on.
Let’s first talk about what buying on margin is.
Buying on Margin
When you buy on margin, you are paying the margin and borrowing the balance from a bank or broker. You’re going to make a down payment to the broker for the asset you want to buy. But before you can do this, you have to open a margin account.
A margin account is very different from a cash account. In simple words, your margin account lets you borrow some capital for your deposit or investment equity. On the other hand, a huge number of brokerages require you to have a minimum amount of equity before giving you a margin account.
Buying on Margin: The Tricks You Must Remember
Even though buying on margin looks like a giant task for investors, there are in fact a bunch of hacks you can do to use it successfully. Here are some tips you can use when buying on margin:
Keep an Eye on Interest Rate
Since you are basically borrowing money, you have to pay some interest for the loan. For stock trading, many online trading brokers charge around 8 percent a year. The rates may vary according to the total portfolio value.
Don’t Buy Everything At Once
Generally, you should buy over time and not in one big shot, depending on your portfolio size. What you can do is try half of your position first. Then, find some firm footing and ride an uptrend or gain ground on the upside. You can start adding to it from then on. If you do it this way, you can minimize your risks until you gain chances of stronger profits.
Avoid Margin Calls
Margin calls are a very bad thing for an investor’s account. When you receive margin call, you will either have to deposit more funds or sell a position completely. You do this to offset your losses on margin. Margin calls happen when the positions you open reach a certain price level. Your best bet is to have a full understanding of prices before your purchase.
Know the Rules
No one can play a game without any rules. That also goes for trading, where investors follow both written and unwritten rules. And you too must play by the rules. If you’re a pattern day trader, you’d be able to borrow more than 100 percent of your account. Of course, you always have to read the brokerage’s guidelines carefully before you start buying on margin.
Choose Your News Carefully
Since you’re playing with borrowed funds, you have to be extra careful with everything, including news. You should choose which upcoming news to monitor. For one, some investors start buying on margin when they think that good news is just around the corner. However, you must still prepare when the tide does not go the way you expect it.
Use Stop Loss Orders
Using stop loss orders can prevent you from receiving margin calls. It can also prevent you from taking further bad losses. Remember that buying on margin magnifies both the chances for winning and losing. And stop loss orders can serve as your insurance against the huge potential losses.
Do not Speculate
Investors who speculate are usually those who are experienced and sure of their decisions. However, it’s extremely not advisable to speculate of margined funds. If you want to follow a disciplined investing, you have to use margin in conjunction with a clear-cut profit vs. loss ratio.
Find a Strategy that Suits You and Stick to It
Most successful traders are those who have picked a specific trading style with which they stuck. Buying on margin is also a lot of things, meaning you can have a shot at various styles. When you find one that really fits you, stick to it and try to improve it.
Make Sure You Have Some Backup Cash
The worst thing that you may experience is to risk it all, and then lose it all. If that happens, you must have some extra funding to prepare for this scenario. It also helps you bounce back from big losses.
Read further: 8 Effective Forex Trading Strategies in 2018
Buying on Margin: Benefits
Now that you have a good grip on how to buy on margin critically, let’s talk about its benefits and risks. Let’s start with the primary benefits you can get when buying on margin.
Related: Several Types of Investment Risks
Chances of Great Returns through Leverage
When you are buying on margin, you have the opportunity to use leverage. When you use leverage, you are attempting to double or triple the returns you can potentially get.
This is one of the most appealing features of buying on margin for investors. After all, one of your main goals in trading is to earn great profits. Leverage can definitely do that.
Better Short Positions
Short selling is one of most sophisticated, and therefore most difficult, strategies for traders. When you go short, you are looking to see the asset’s price to decline.
Buying on margin lets you borrow shares of a stock from the brokerage. Then, you sell them on the market, waiting for the price to fall. Afterwards, you buy them again later when the price declines as expected. Then, you give it back to the broker.
To calculate how much you earned, you can subtract the amount you paid to buy them back from the amount you sold them.
Diversification
Remember that putting all your eggs in one basket is very dangerous. You can lose all of your investment if your portfolio is too concentrated on one kind of stock or asset. You should always diversify.
Buying on margin lets you use those stocks as collateral for your margined loan. You can use the loan to diversify your portfolio while not selling your first assets.
Line of Credit
If you’re lucky enough to have an approved margin account for borrowing, you can have a convenient line of credit.
This means that you can have some margin loans at almost any time. Generally, you don’t have to fill out additional applications or forms. This makes you ready for situations when you need cold cash due to some reasons. Some brokerages give checking services, so there’ll be times when you can simply write a check.
Comparatively Lower Interest Rates
As we have mentioned, buying on margin is basically a loan. And just like any other loan, you have to shoulder some interest rates.
The good news is that margin-related interest rates may be lower than others. This is because the rates of a margin loan attach themselves with the Fed’s target rate. In addition, margin loans can also be competitive on home equity loans. You won’t have to go through the tedious paperwork and application fees.
Repayment Schedule
As we have indicated above, you should avoid receiving a margin call. To do that, your debt should exceed the approved margin maintenance requirement. All things considered, you can repay them in your own time.
Advanced Options Trading Strategies
When you have a margin account and do options trading at the same time, you can access advanced options orders.
These advanced orders include butterflies, spreads, and uncovered options on various securities. And these securities include equities, exchange-traded funds, and indexes.
See also: Most Popular Type of Mutual Funds and Everything in Between
Buying on Margin: Risks and How to Manage Them
Of course, if there are benefits, there are also inherent risks. Let’s see what they are and see how we can manage them properly.
Leverage Risks
When you use leverage, you’re not only magnifying your earnings chances, you’re also magnifying loss dangers.
This is why only long-time and experienced investors use leverages. If you still plan to use it, you must have highly professional risk management. You should also be aware that your risk tolerance might not match risks of leveraging.
Failing to Meet a Margin Call
You have to maintain a certain percentage of equity in your account. It depends on the kind of securities you own. It may also depend on the transactions you do, like borrowing money or additional shares, or going short.
In case your collateral securities’ value falls below the minimum maintenance amount, you may receive a margin call. And if you receive a margin call, you’ll be compelled to add more cash or securities into your account. If you fail to respond quickly, your brokerage can sell your securities without notice to increase your account’s equity.
How to Manage These Risks
Here some of the things you can do improve your risk management. Be sure to try to follow them to reduce the risk you face.
- Leave an amount of cash cushion in your account. This could reduce the chances of receiving a margin call.
- Study volatility and prepare for it. Develop a strategy that can position your portfolio where it’s flexible to any fluctuation.
- Set a point when you will add more financial resources to your margin account.
- Interest fees are low but they accumulate eat away on your earnings. Be sure to pay them regularly.
- Invest in assets with big return potential. Make sure that the securities you’re buying on margin can give you returns higher than the interest of the loan.
- Never risk more than 5% of your account on a single trade.
- Resist the temptation of overtrading.
Related: 11 High-Yield Investments Risk Takers Should Know
Conclusion
Overall, buying on margin can be really tricky for new investors. That’s why further research and assessment are important if you’re planning to buy on margin. This trading style can be extremely profitable and convenient if done properly. However, it could also wreak havoc on your capital if done carelessly.
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