Margin Trading is a practice that is often misunderstood or unknown to beginners. So, in this article, we will give you some insights of what it is, the pros and the cons of margin trading.
Simply put, when you trade on margin, you basically borrow funds from your broker which allows you to trade a financial asset on leverage. That means you can for example buy a stock for 50% of its value, the rest of the capital being supplied by the broker. Therefore, it allows you to purchase more assets than could have normally. When you sell, the funds are used to repay the inital loan. Margin trading is a strategy that can potentially be very rewarding but also very risky so it should be use very carefully.
Trading on marging gives you the opportunity to leverage your gains by allowing you to buy more assets than you could have with your own funds only. Therefore, the return on investment can potentially be a lot bigger than with traditional trading. Margin trading is a great way to take advantage of opportunities as they present themselves as well. You don’t need to raise extra cash or liquidate other assets to go for that golden trade which would probably be gone by the time you found a way to transfer these funds to your trading account. Margin trading also enables you to short sale an asset. Short selling (or shorting) is the sale of an asset or instrument that you’ve borrowed from your broker and that you can buy back later at a lower price and therefore make a profit. For more information about short selling, check out our full article on this matter.
The main issue with margin trading is that you can potentially lose more than 100% of your initial investment. Let’s suppose that you lost it all on a few bad trades. Now not only you’ve lost your own capital but you also need to repay the funds that you borrowed from your broker as well as interest rates. This can get terrible when playing with big amounts. Besides, margin trading also involves a maintenance margin which is the minimum account balance you must maintain at any given time. If you fail to do so, you broker can force you to deposit more funds or even sell your assets in order to pay down your loan. This is known as a margin call. Again, this can be dreadful with dealing with large sums of money.
Margin trading is a double-edged sword. On one side, it can be extremely profitable but the losses can be devastating. Since there are no guarantees in the financial markets, you should be extremely careful when trading on margin and understand the consequences of your actions. We strongly recommend to leave it to experienced traders only.