Besides the ability to borrow funds for investment, how is a margin trading account different from a cash account? Cash and margin account Stock market margin account

All traders who speculate in the financial markets use a trading account in their work, on which transactions take place. Under the terms of brokerage companies, they have margin lending. All financial transactions performed by speculators are leveraged. What is margin, in simple words - lending for trading? This, as well as its features and rules of use, will be discussed in the article.

Margin concept

In trading on financial markets, loans with margin conditions are provided by brokerage companies to all clients without exception. This allows speculators to trade on more favorable terms. What is margin? In simple words, this is a special type of loan for trading in financial markets. This type of provision of additional funds allows clients to use trading assets with financial leverage. That is, a trader can make deals on more favorable terms with an excess of the volume of his own deposit money.

With the help of leverage, the speculator has the opportunity to use in his transactions additional funds provided by the brokerage company. It has its own parameters and conditions for each trading account, the most important of which is the issuance of a loan secured by the trader's own deposit funds, which are on his account.

Leverage

When a client registers with a brokerage company and draws up an account for work, he can choose the most acceptable option for him ("Standard", "VIP", "Micro" and other types). Most often it depends on the free amount of money that the speculator is willing to risk, that is, on his deposit.

Leverage is the ratio of the total amount of funds in the trading account to the lot size. Usually, these conditions are specified in the contract, but there are brokers that allow clients to choose them on their own.

Leverage types:

• 1:10;
• 1:25;
• 1:50;
• 1:100;
• 1:200;
• 1:500;
• 1: 1000 and other options.

The higher this indicator, the more opportunities a trader has in speculative operations. But it is also necessary to pay attention to the fact that financial risks are also increasing. Therefore, when choosing the type of trading account, you need to take into account that trading with a large leverage in case of unsuccessful trading will quickly lead the speculator to a Margin Call, that is, the loss of most of the deposit.

The essence of margin trading

In "Forex", as in other areas of financial markets trading, there is no actual sales. When they say that traders buy or sell any assets, in fact, this does not happen, since all transactions are based only on predicting changes in market quotations. In trading, one makes money on assumptions that can be determined by many instruments based on price changes. A trader's income consists of speculative transactions and is calculated on the difference between buying and selling an asset.

The essence of the margin principle is exchange operations with trading instruments, without actual sales or purchases. All transactions take place through arbitration. For clarity, you can consider an example. The speculator selects a trading asset and places a buy order. Another trader opens a sell position for the same instrument. In this case, the volumes of the lots must be the same. After a while, an exchange takes place. As a result, one speculator makes a profit and the other a loss. The earning of the first trader will depend on the lot size and the number of points earned.

Margin lending allows traders to significantly increase their income. This is due to the ability to place large volumes, which are calculated in lots. Let's say a deal with one whole lot will be 10 cents per 1 point on a micro account, in standard versions this amount will increase 100 times - up to 10 dollars with lot volumes of 0.1 - 1 cent or 1 dollar for standard types.

Features of margin trading

A loan issued by brokerage companies differs significantly in terms of its terms from all other loan options. Let's consider its features:

1. Loan funds are issued only for trading. They cannot be used for other needs.
2. Additional amounts are intended for trading only with the broker that issued them. In exchange trading, including on "Forex", having registered an account with one dealer, it is impossible to use deposit funds in work with another broker.
3. Margin credit is always much more than a trader's own funds, in contrast to consumer, bank and other types of loans. That is, it is several times larger than the amount of the collateral or margin.

The margin lending regime significantly increases the total volume of transactions. For example, on Forex, the size of one whole standard lot is 100 thousand USD. e., or US dollars. Naturally, not every speculator has the necessary amount of money to make transactions. Even average market participants cannot afford such large deposits with high financial risks, from which there can be no insurance, only their minimization.

Margin lending allowed even small market participants to take part in trading through brokerage companies and make money using leverage. As a result, the total volume of transactions has increased significantly.

How do I calculate the margin?

In exchange trading, the parameters of the collateral or margin are very important. When choosing a trading account, it is always necessary to take into account the size of the leverage and the percentage for the Margin Call, that is, the level of residual funds before the forced closure of the transaction by the brokerage company.

Depending on the conditions for obtaining a margin loan, this indicator may be different. Somewhere it is 30%, while other brokers have 0% or less. The higher this indicator, which is also called Stop Out, the less trading opportunities there will be, but if the deal is forced to close, the loss will be much lower.

For example, a trader's trading account has a deposit of $ 1,000. With an incorrectly opened position, when the market went against his trade, it will be closed with a Stop Out of 30 percent, when the speculator receives a 70% loss, that is, $ 700, and after the execution of the Margin Call, $ 300 will remain on his deposit. If the Stop Out value is 10% according to the trading conditions of the account, then the loss will be $ 900, and only $ 100 will remain.

The formula for calculating the margin is as follows: the margin will be the lot size divided by the leverage.

Variation margin

What it is? Any deal, no matter how it was closed - with profit or loss, is displayed in the trader's statistics in his trading terminal. The difference between these indicators is called the variation margin. Each brokerage company sets a limit, that is, the minimum value for the speculator's deposit funds. If the level of the variation margin in trading falls below these parameters, then the broker's client will be considered bankrupt, and his funds will be debited from the deposit account.

To exclude possible financial losses, brokerage organizations set special levels on clients' trading accounts, upon reaching which a Margin Call will follow. The trading terminals display a warning from the broker that the deposit reaches the minimum balance line. In this case, the trader has only one option - to replenish his trading account or he will be forced to close with a loss. Margin lending provides for a range of this level in the range of 20-30% of the collateral of funds.

If the client does not replenish his account, then his balance will decrease, and in this case, all positions, if there are several of them, will be closed by Stop Out, regardless of the trader's wishes. In other words, upon a decrease in the balance on the trading account and the balance of the collateral by 20-30%, the broker issues a warning to the client - an offer (Margin Call). And then, when the losses reach large values, and only 10-20% will remain in the collateral, but the deposit will not be replenished, it closes the deal - Stop Out forcibly.

Stop Out example

How is the forced closing of positions carried out? In practice, it looks like this:

1. Let's say a speculator has a trading account from the "Standard" category.
2. The size of his deposit is 5 thousand US dollars.
3. He chose the euro / dollar currency pair as a trading asset.
4. The leverage is 1: 200.
5. The volume of the lot is standard for "Forex" - 100 thousand US dollars, that is, the size of the deposit is 5 thousand dollars, multiplied by the leverage of 200.
6. The amount of the collateral in this example will be 10%, that is, $ 500.
7. He opened only one deal, but incorrectly predicted the change in market quotations, and it began to give him losses.
8. Initially, he received a warning in the terminal - Margin Call, but did not take any action and did not replenish his deposit.
9. The deal was closed by Stop Out with the level of 20% set according to the trading conditions of the account. The trader's losses on the deal amounted to USD 4,900. There is only $ 100 left on the deposit.

This example shows how dangerous it is to use a large amount of leverage, and the consequences for the trading deposit. When trading, you should always monitor the size of the margin and open positions with small lot volumes. The higher the margin funds, the higher the financial risks.

In some brokerage companies, you can independently disable the service for providing margin trading. In this case, the financial risks at marginal lending rates will be maximum and amount to 100%, and leverage will simply be unavailable.

Margin agreement

All trading conditions for accounts provided by brokerage organizations are spelled out in the contracts. The client preliminarily looks through them, gets acquainted with all the points, and only then signs.

Online, when a trader does not have the opportunity to visit the office of a brokerage company, he gives his consent to the agreement automatically when registering a trading account. Of course, there are also such organizations that send documentation through a courier or "Russian Post". The form of the agreement on margin lending is determined by the trading conditions, which spell out all the requirements and regulations.

Short and long positions

Each speculative trade has two stages: opening and closing a position. For any trade to be considered complete, a full cycle of the trade is required. That is, the short position must necessarily overlap with the long one, and then it will be closed.

Types of speculative transactions:

1. Trading on the upward movement of quotes - opening long positions. Such transactions in trading on financial markets are designated - Long, or purchases.
2. Trading on a falling movement of quotes - short positions, that is, selling, or Short.

Due to the regime of margin lending, trading in financial markets has become very popular not only among large participants such as central banks, commercial and insurance funds, organizations, companies and enterprises, but also among private traders who do not have large capital.

Small speculators can earn in trading with relatively small amounts, and in most cases, only 1 to 3% of the total value of the transaction will be enough. As a result, with the help of margin trading, the total volume of positions increases significantly, and the volatility and liquidity of trading assets on exchanges increases, which leads to a significant increase in cash turnover.

All positions opened in Long (long) are characterized by the conditions for the upward movement of the market. And short (Short) - for the descending one. Buy and sell deals can be opened with different time periods. There are three types of them:

1. Short-term positions ranging from a few minutes to 1 day.
2. Medium-term deals - from several hours to a week.
3. Long-term positions - can last for several months or even years.

In addition to the time period, the trader's earnings depend on the chosen trading asset. They all have their own characteristics and characteristics, and the greater their liquidity, volatility, supply and demand, the higher the speculator's profitability will be.

Positive and negative aspects of margin trading

The more leverage a trader's trading account has, the more the financial risks of the transaction increase. Margin lending provides the following advantages for the speculator:

1. Possibility of opening a position with a small capital of own funds.
2. Due to leverage, a trader has advantages in the market and speculative manipulations can be performed in trading using a wide variety of trading strategies.
3. The credit margin is provided in a significantly larger amount of available collateral and increases the possibilities of deposit funds tens and hundreds of times.

The negative aspects include the following characteristics:

1. Margin trading, increasing the liquidity of the market, increases the price fluctuations of asset quotes. As a result, it is much more difficult for traders to accurately predict price changes, and they make mistakes when opening positions that lead to losses.
2. The leverage used in margin lending significantly increases the speed to generate income, but at the same time, if the case is unfavorable, it has a large impact on losses. That is, with it you can both earn very quickly and lose your deposit funds.

Professionals advise beginners to be very careful when choosing the terms of a trading account, to use the optimal leverage option in trading and pay attention to the characteristics of assets. It should be remembered that volatility can be not only a friend of the trader and allow him to make quick money, but also an enemy that leads to instant and significant losses.

Free margin

In any trading terminal, you can see such a parameter as free margin. What it is? Free margin is funds that are not involved in trading and in collateral. That is, this is the difference between the total amount of the deposit balance and the credit collateral margin. It is calculated only in open positions during the validity of the order, but as soon as the speculator closes it, then all the collateral is released, and the total amount of the deposit is indicated in the terminal.

Free margin helps to determine during trading what opportunities are available to a trader, how many and in what lot volumes he can still open deals at the current time.

Conclusion

Margin lending opens up great opportunities for making money in the financial market for medium and small market participants, as well as for private traders. Professionals advise beginners to pay special attention to trading conditions and leverage when choosing a type of deposit account.

Margin account -this is an account with a brokerage margin on the exchange. This account allows you to participate in purchases of securities on the stock exchange using borrowed capital from a broker. In the event of a fall in the value of shares, the owner must replenish it in cash or sell part of the securities.

The funds on the account are the pledge of transactions. A margin account is called a trading account or a deposit.

It is used when trading on the principle of leverage. The maximum purchase amount is calculated based on the funds available in the account. To open trading positions, you must have the required minimum funds on the account, it is set separately by each exchange. The balance of the margin account cannot be negative, otherwise all open positions are closed and no deals are made. Funds serve as insurance when making unprofitable transactions.

Main indicators of the margin account:

• The active balance is the amount of funds, which is the difference between the account balance and the results of trading. This metric is usually calculated automatically and displayed continuously. This indicator allows you to track how profitable or unprofitable open trading positions are.

• Total balance - the amount of funds in the margin account.

• Funds available for trading.

• Funds that are currently pledged for an ongoing transaction are called blocked margin. They cannot be debited from the account, and are not available during the period of the transaction. Blocked funds can be debited from the account after the transaction, if it turns out to be unprofitable.

• Available margin is an indicator that reflects the difference between funds blocked as collateral and free for trading. The available margin allows you to determine how many trade positions can be opened with the current balance. If the available margin is large enough, then there is funds to complete several transactions.

Only one indicator is constantly changing - the overall balance, depending on the number of transactions and their profitability.

Margin call

It is required to constantly monitor that the available margin is as large as possible and does not approach zero. In the event that the available funds become insufficient to maintain trading positions, the broker announces a margin call, and all positions are forcibly closed. Usually brokers give a signal in advance.

Passive balance - the state of the margin account with closed transactions. After the trading positions are closed, it is possible to determine the trading result and calculate the profit or loss. The leverage is not displayed and does not affect the final calculation, it is only required to open a deal.

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Probably the most significant difference is the sword of Damocles hanging over your head, the Margin Challenge.

In a nutshell, the lender (your broker) will require you to have a certain amount of assets in your account in relation to your outstanding loan balance. The minimum liquidity to credit ratio is regulated in the US at 50% for the initial margin and 25% for the service margin.

So this is where it gets sticky. If this ratio turns out to be on the wrong side of the limit, the broker will force you to either add more assets / cash to your t account, or immediately liquidate some of your holdings to remedy the situation. Assuming you don’t / have enough cash to fix the problem, it can effectively force you to sell while your investment is in the reservoir and block large losses. In fact, most margin agreements give brokerage organizations the right to sell their investments without your express consent in these situations. In this situation, you won't even be able to choose which stock they are selling.

Here's an example from the article:

Let's say you buy $ 20,000 worth of securities by borrowing $ 10,000 from your brokerage and paying $ 10,000. If the market value of a security drops to $ 15,000, the equity in your account drops to $ 5,000 ($ 15,000 - $ 10,000 = $ 5,000). Assuming a 25% service requirement, you should have $ 3,750 in (25% of $ 15,000 = $ 3,750). So in this situation you are fine as the $ 5,000 equity in your account is more than the $ 3,750 safety margin. But suppose your brokerage company's content requirement is 40% instead of 25%. In this case, your net worth of $ 5,000 is less than the $ 6,000 safety margin (40% $ 15,000 = $ 6,000). As a result, the broker can issue you a margin call.

With margin accounts, you can use the proceeds from a closed trade INSTANTLY. Without margin accounts, this is the time you close the trade + 3 business days for clearing. In practice, this means 4-5 days if there are weekends or holidays within three working days. This ties up your capital for an unfavorable period of time, when as a margin account, you can continue to use capital over and over again to gain more opportunities.

You CANNOT sell to open a position in cash accounts. This means no short selling. This means no calls or spreads covered and LOTS of other strategies.

These are the real differences you will notice in a margin account versus a cash account.

Then there are many rules that govern how much money you should keep in your account for any given margin position.

• Cash accounts do not allow short positions, except for covered calls or places
• Day trading has different restrictions in the two types of accounts
• Sales proceeds are immediately available in margin accounts.
• The margin will allow you to scan the delay between the start and the credit for the deposit
• A margin account is like any other line of credit, and part of your credit report
• Margin accounts can carry significantly greater risk

Long form:

Spreads and shorts are not permitted in cash accounts, except for closed options. Brokers will allow clients to roll up option positions in a single transaction, which look like spreads but are not really “sell open” transactions. “Sell to open” is prohibited on cash accounts. Short positions from the close of the long half of the closed trade are verboten.

Day trading is allowed for both margin and cash. However, "day trading with templates" only applies to margin accounts and requires a minimum account balance of $ 25,000. Cash accounts are free to buy and sell the same security over and over again on the same day, provided there is sufficient purchasing power to pay for opening a new position. Since revenue is posted to both stocks and options in cash, this means that the purchasing power available at the start of the day will decline with each purchase, rather than increase prior to settlement.

Unexpected funds are available immediately on margin accounts without restrictions. On cash accounts, using unresolved funds to buy securities will require you to place a new position until the funds are settled - otherwise your account will be blocked for a "free ride".

Legally, you can buy securities in a cash account with no cash on deposit from a broker, but most brokers do not allow this, and some of them will aggressively liquidate any position that you can somehow enter for which you did not have available cash is already on the deposit. In a margin account, margin can help mask a few days between buy and deposit, allowing you to be more aggressive in your investment.

A margin account will allow you to make an investment if you feel like it is right before requiring funds to be deposited. See this great opportunity? With enough stock, you can open a trade immediately and then go to the bank to deposit funds, and not get stuck waiting for the funds to be credited to your account.

Margin accounts may appear on your credit report.

The opportunity to lose more than you invested, having positions liquidated when you least expect it, your broker doing possibly stupid things to close an overly margin account, and the other consequences are very serious margin account risks. Although you mentioned this issue, any answer is incomplete mentioning these risks.

Two more esoteric differences related to the same cause ...

When you have an outstanding loan balance, margin can lend your securities to short sellers. (They might be able to borrow them even if there is no debit balance - check your account agreement and related rules). You will never know about it (there is no indication in your account) unless you ask, and maybe not even then.

If the securities pay dividends when issued, you do not receive dividends (directly). Dividends are passed on to the person who bought them from the short seller. The short seller must pay the dividend amount to his broker, who pays them to your broker, who pays them to you. If the dividends paid by the securities were qualified dividends (maximum rate 15%), then the qualification goes to the person who bought the guarantee from the short seller. What you received was not a dividend at all, but dividend payments and qualified dividend payments are not available to them.

Some (many?)? Brokers will pay you a gross payment to compensate you for the additional tax that you had to pay because of your qualified dividend on that security not actually qualified.

A similar situation occurs if shareholders vote. If stock was provided on the registration date to establish eligibility to vote, the eligible person is whoever bought them from the short seller, not... Therefore, if for some reason you really want / need to vote in the voting of shareholders, call your broker and ask them to register the said shares on the money side of your account before the registration date to determine eligibility to vote.

Theoretical article ( with my comments). May be useful for beginners. If you are familiar with the concept of leverage, then this article will not interest you. The fact is that "margin trading" is, in fact, synonymous with the concept of "leverage".

Margin trading is the conduct of speculative trading operations using money and / or goods provided to the merchant on credit against the security of an agreed amount - margin. Marginal differs from a simple loan in that the amount of money received (or the cost of the goods received) is usually several times higher than the amount of the collateral (margin).
For example, for granting the right to conclude a contract for the purchase or sale of 100 thousand euros for US dollars, the broker usually requires a deposit of no more than 2 thousand dollars. This allows the trader to increase the volume of transactions with the same capital.

The margin principle is widespread in exchange trading with any instruments.

Find out what is
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Conditions for obtaining a margin loan

Margin trading involves the implementation of transactions with assets received from a broker on credit. It can be both cash and tradable goods: for example, stocks, fixed-term contracts. Margin lending has its own specifics. Usually the following conditions are stipulated:

Obtaining a loan does not require prior approval and specific registration.
The loan is secured by cash and other assets placed on the relevant accounts.
The loan provides assets from the list of assets with which margin transactions can be made.
Credits are provided free of charge during the trading session.
It's in the stock market. On Forex, loans are free even if the transaction is held for longer than 1 trading session.

The size of the margin requirements is highly dependent on the liquidity of the traded product (and from a specific broker)... In the foreign exchange market, the margin is usually 0.5 - 2%. The stock market can be 20 - 50%.

Features of margin trading

Margin trading always assumes that the trader will certainly carry out the opposite operation for the same volume of goods after some time. If the first was the purchase, then the sale will definitely follow. If there was a sale first, then a purchase is definitely expected.

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Read also the article.
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After the first operation (opening a position), the trader is usually deprived of the opportunity to freely dispose of the purchased goods or funds received from the sale. He also pledges part of his own funds in the amount of the agreed margin as collateral.

The broker closely monitors open positions and controls the amount of possible loss. If the loss reaches a critical value (for example, half of the margin), the broker can contact the trader with a proposal to pledge additional funds.

This call is called Margin Call - from the English. Margin call (literal translation - margin requirement).

If the funds are not received, and the loss continues to grow, the broker will forcibly close the position on its own behalf. After the second operation (closing the position), a financial result is formed in the amount of the difference between the purchase price and the sale price, and the security margin is released, to which the result of the operation is added.

If the result is positive, the merchant will receive back more funds in the amount of profit than he pledged. If the result is negative, the loss will be deducted from the collateral and only the balance will be returned. In the worst case, nothing will remain of the collateral.

In the good old days (several decades ago) brokers called clients and said that “Your current deal is unprofitable, if you don’t add more money, then we will close the deal (fix the loss)”. Now, unfortunately, no one calls. Automation itself closes a losing trade when a Margin Call occurs ...

The merchant does not bear any additional financial obligations to the broker for the loan received, except for the provision of margin. Usually, a broker cannot make a demand for the provision of additional funds on the grounds that the position was closed with a loss that exceeded the amount of the provided collateral.

This situation can occur at the opening of a new trading day, when trading begins with a strong gap from the previous day's quotes. In this case, the risk of additional losses lies with the broker. This is the fundamental difference between margin trading and trading using conventional credit. In this, margin trading is similar to gambling, where the risk is usually limited to the size of the bet. (It happens in different ways, for example, Alpari reserves the right to demand compensation for losses on the account).

In order to be able to conduct margin trading, a broker usually does not provide the trader with full ownership of the instruments traded or requires a special collateral agreement. The trader should not be able to interfere with the forced closing of positions by the broker.

Very often, the goods and / or proceeds from the sale are not transferred to the property of the merchant at all. Only his right to give an order to buy / sell is taken into account. As a rule, this is sufficient for speculative transactions, when the trader is not interested in the object of trade, but only in the opportunity to make money on the difference in price. This kind of trading without real delivery reduces the speculator's overhead.

You may like the article about the one you are working with.
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Benefits for the merchant

- Allows the trader to multiply the volume of transactions without increasing the required capital.
- Allows the trader to conduct transactions in capital-intensive markets even without having their own significant sums of money.
- Provides the technical ability to make a profit when prices fall.

Benefit for the broker

Additional income in the form of interest payments for the use of the loan. Interest on a margin loan is often significantly higher than interest on bank deposits (it is more profitable for a broker to use funds for margin lending to clients than to place funds on bank deposits).

The client makes transactions for a larger volume, which leads to an increase in the broker's commission, including in the form of a spread at brokers-market makers.

Risks

The use of leverage proportionally increases the rate of income when the price moves towards an open position. However, with the opposite price movement, the rate of growth of losses increases to the same extent. This can lead to both very quick enrichment and rapid loss of capital.

Criticism of margin trading

Classic equity investors (such as Buffett et al.) Often speak very unflatteringly about the use of leverage and margin trading.
Buffett even called it "Weapons of Mass Destruction" - hinting that this instrument is very risky and leads to the massive destruction of investors' trading accounts.

The way it is.
But…
In Forex, the size of market fluctuations is quite small (several times less than in the stock market). Therefore, if you do not use margin, then it makes sense to engage in Forex - no! (there will be too little profit comparable to the rate on a bank deposit).
That's it…

Watch the thematic video:

Sincerely. Arthur Bykov.

Imagine: during a game of blackjack, an ace comes to you. You want to increase your bet, of course, but you are tight on cash. Luckily, your friend offers you $ 50 and says you can return it later. Tempting, isn't it? If a good card comes up, you have a chance to get a big win and give your friend his $ 50, keeping the proceeds for yourself.

But what if you fail? Not only will you lose your initial stake, but you will still owe your friend $ 50. Cash loans at casinos are like gambling on steroids: the stakes are high, as is the potential for profit, and at the same time, your risks increase too.

Investing on margin isn't always like gambling. But there are still some parallels between margin trading and casinos.

Margin is a risky strategy that, if used correctly, can generate huge profits. On the other hand, you can also easily be left with nothing and lose everything that you have invested. More dangerous than margin investing can only be margin investing without understanding how it works. With this guide, you will learn everything you need to know.

Basic Provisions

Buy on margin means borrowing a loan from a broker to buy securities. You can think of it as a commission-based loan.

Trading on margin allows you to buy more securities than would normally be possible. To conduct margin transactions, you will need to open a margin account. It differs from a standard cash account, which is traded using the money available on the account. A margin account can be part of a standard account opening agreement, or it can be regulated by a completely separate agreement.

To open a margin account, you need to make an initial investment, the minimum volume of which is $ 2000, although some brokers ask for more. This contribution is called the minimum margin. When the account is open and ready to work, you can borrow up to 50% of the value of the security. This portion of the value that you deposit into the deposit is called the initial margin. It is important to know that you do not need to bring your margin up to the full 50%. You can borrow less: say 10% or 25%. But it should also be borne in mind that some brokers require more than 50% of the purchase price to be deposited.

You can hold your loan for as long as you like, provided that all obligations are met on your part. First, when you sell a security through a margin account, the proceeds go to your broker to pay off the loan until it is paid in full. Secondly, there is also a restrictive requirement, the so-called maintenance margin - the minimum balance on the account that you must maintain so that the broker does not force you to invest large funds or sell securities to pay off the loan debt. In this situation, the term "margin call" is applicable.

Cash loans don't come for free. Unfortunately, the margin securities on the account are additional collateral for the loan. You will also have to pay interest on the loan. Interest will be charged to your account if you do not make a payment. Debt levels rise over time as interest charges accumulate and don't play into your hands. With the growth of debt, the interest on the loan also increases, and so on.

Therefore, buying on margin is mainly done for the purpose of short-term investment. The longer you hold on to the investment, the more revenue is needed to cover costs. If you delay investing on a margin basis, your ROI will be negative.

Not all securities are eligible for buying on margin. The Board of Governors of the Federal Reserve System determines which securities are suitable for margin trades. As a general rule, brokers will not allow buyers to buy too small shares, securities traded outside the exchange, or securities on an IPO on a margin basis due to the current risks that accompany such securities. Private brokers may also decide not to carry out margin trades involving certain securities, so it is necessary to clarify in advance the restrictions that apply to your margin account.

Purchase example

Let's say you have deposited $ 10,000 into your margin account. Since you are investing 50% of the purchase value, that means your purchasing power is $ 20,000. Then, if you buy $ 5,000 worth of securities, you still have $ 15,000 left, which is your purchasing power. You have sufficient funds to cover this trade, you have not used your margin reserve. You only start borrowing when you buy securities worth more than $ 10,000.

This brings us to an important conclusion: the purchasing power of a margin account changes on a daily basis depending on the fluctuations in the value of the margin securities in the account. Next, we will examine what happens when a security rises or falls.

Why use margin trades at all?

Threat of margin call

In volatile markets, prices can fall very quickly. If the balance (value of securities minus the amount owed to your broker) of your account falls below the maintenance margin, the broker can make a so-called "margin call". A margin call forces the investor to either sell existing assets or add more cash to the account.

This is how it works. Let's say you buy $ 20,000 worth of securities by borrowing $ 10,000 from your broker and depositing $ 10,000 yourself. If the market value of securities falls to $ 15,000, your account balance will decrease by $ 5,000, respectively ($ 15,000- $ 10,000 = $ 5,000). Taking into account the requirement to maintain 25% in the account, the capital on your account must be $ 3750 (25% of $ 15,000 = $ 3750). Thus, in this situation you are safe, as the $ 5,000 in your account is more than the established maintenance margin of $ 3,750. But let's assume that your broker requires you to maintain a balance of 40% instead of 25%. In this case, the amount of $ 5000 in your account is less than the required maintenance margin of $ 6000 (40% of $ 15000 = $ 6000). As a result, the broker may contact you with a margin call.

If for any reason you have not received a margin call notification, the broker has the right to sell your securities to achieve the required account balance above the maintenance margin. Even scarier is the fact that your broker may not be required to consult with you before selling. Under most margin agreements, the firm can sell your securities without waiting for you to receive a margin call. You cannot even influence which securities are sold to cover the margin call.

For this reason, it is imperative that you read your broker's margin agreement very carefully before investing. This agreement covers the conditions for maintaining a margin account, including the following: how interest is calculated, your obligations to repay the loan, and how the securities you purchase serve as collateral for the loan.

Risks

As you can imagine, margin accounts are risky and not suitable for all investors. Leverage is a double-edged sword: both losses and profits increase equally. In fact, one of the definitions of risk is the degree of fluctuation in the price of an asset. As leverage amplifies these fluctuations, by definition, the risk to your portfolio also increases.

Returning to our overestimated profit example, suppose that instead of skyrocketing 25%, our stocks fell 25%. Your investment would now be worth $ 15,000 (200 shares x $ 75). You sell papers, pay your broker $ 10,000 and stay with $ 5,000. That's a 50 percent loss, plus commissions and interest, which otherwise would have been only 25 percent.

Think losing 50% is bad news? It could get much worse. Buy on margin is the only type of securities-based investing where you must be willing to lose more money than you put in. A drop of 50% or less would mean more than a 100% loss for you, with commission and interest on top of that.

When working with a cash account, there is always a chance that the shares will be rehabilitated. If the fundamentals of the company are not changing, you might be better off waiting for the environment to improve. And, if that gives you any consolation, your losses are just potential losses until you decide to sell the stock. But as you remember, with a margin account, your broker can sell your securities if their rate drops sharply. This means that your losses are fixed and you will not have a chance to benefit from possible future price surges.

If you are new to the investment business, then we strongly recommend that you stay away from margin. Even if you feel ready to engage in margin trading, remember that you do not need to borrow the full 50%. Be that as it may, only venture capital should be set aside for margin investments - that is, the money you can afford to lose.