So, maybe you are new to the world of stocks and you feel that even though everyone is speaking English, it’s as if this is a whole new language than what you are used to. Don’t worry, you are not alone.
The stock market is a fast-paced and ever-changing environment. Getting into it is much like jumping into a raging river and learning not to drown at first. Once you can stay above water, you get the hang of steering the rapids quite quickly. One of the first terms you will get well acquainted with is margin.
So, what is margin?
In layman’s terms, it is a special loan, a stock loan that your brokerage undergoes to acquire stock that you would otherwise not have been able to buy with the money that you have available. However, to get the loan, you have to apply for and open a margin account.
This is no ordinary loan, and the stakes are much higher. Therefore, the brokerage that approves the loan will use any stocks and cash as a type of security. A loan will only be approved for half of the value in stock and cash that a firm has in an account.
Newer investors who have had a whiff of success often opt for margin in the hopes of improving their stock market returns. You also won’t find long-term investors dabbling in margin as the risk becomes higher over time. Short-term investors usually go for margin and can make quick sales to boost revenue.
If you want to use margin, you have to know which stocks to play around with and that is the risky part. The most attractive stocks for maximizing profit are stock that has high volatility. The fluctuations in value need to be substantial to make the buy worth the risk.
The traders need to be on top of their game and keep a close eye on proceedings, seeing that a late sell could result in a major loss. On the other hand, when the pendulum swings towards the profitable end, the trader will aim to sell at the last moment to increase the profit margin.
Making it practical
Let’s say that you are a new investment broker and you want to get going fast. You successfully apply for margin and start playing around. On the first round, you buy stock for $500. However, you used 50% of your own money and 50% margin. Lucky for you, the stock price goes up to $750.
If you had used all of your own money to buy the stock, you would have only made a $250 profit. However, seeing that you used loaned money, your profit jumps to $500. Although you have to pay back the loaned money, your return on investment was significantly higher.
On the other side, you could incur major losses if the scenario is reversed. Let’s say you bought $500 stock and used your margin money. Before you know it, the stock value takes a nosedive and eventually you sell for $250. The result is a 100% loss of your own money seeing that you have to pay the brokerage that loaned you the money back. In fact, the loss is more than 100% because you have to pay interest on what you borrowed.
The dreaded margin call
No one said that the world of stock trading was a forgiving one. In fact, when things look as if they are going south, brokerage firms tend to tighten the strings and give out margin calls. Like anyone else, they want to protect their assets.
Margin calls are a trader’s worst nightmare because they come at the worst possible time. A brokerage firm will stipulate the maintenance margin in the contract and watch proceedings with a close eye. This maintenance margin is like the brokerage’s insurance for when things go south.
When the shares drop, a brokerage is within their rights to demand more money be put into the margin account to keep the agreed upon maintenance margin. As the trader, you have no choice but to sell even though the market might turn.
To use or not to use?
Using a stock loan to create leverage is a very alluring prospect for young traders. However, the risks involved could ruin you before you even get started. As the saying goes, slow and steady wins the race. You don’t have to go all in or have all your eggs in one basket. Instead, work towards smaller attainable goals and build your empire one successful trade at a time.
Feel free to drop a comment or share your views. The Chartists would love to hear your thoughts on the matter and maybe learn a thing or two in the process.