Margin trading allows traders to borrow money from a broker to open a position much higher than their current financial capacity. Margin, itself, is an amount a trader deposits with a broker to borrow funds—explained with the precision of a ghostwriting . Brokers have varying margin rates, which are represented as a percentage.
That said, getting started with margin trading can be a bit overwhelming. You would come across numerous experts giving varying advice. Pause everything for a while and analyse the pros and cons.
Here’s a short guide explaining the advantages and risks of margin trading:
Advantages of Margin Trading
The benefits of margin trading include:
Increasing purchasing power
Most traders choose margin trading for one primary reason: Leverage. Margin trading boosts the purchasing power of traders, increasing the available capital. You can gain exposure to a load of financial instruments, such as stocks, indices, ETFs, and Forex. Your personal capital remains secure.
Let’s say you want to buy shares in a company, and the total cost is $1,000. With margin trading, you’d only have to pay a certain margin rate, say 20%, and the broker will cover the rest. In this case, you’d only pay $200.
Greater gains
Now that you have the ability to buy more securities, you have a better shot at amplified profits. Margin trading is excellent for traders who want to capitalise on short-term price fluctuations but are facing a capital shortage. Leverage will also put you in a more favourable condition in the market.
Portfolio diversification
For long-term investors, margin trading is a standout way to ensure portfolio diversification. You can gain better market exposure and test different trading strategies.
Flexibility
Margin trading is similar to borrowing or taking out a loan. But the terms are more flexible. You don’t have to follow a fixed repayment schedule, and many brokers have simplified margin requirements.
Risks of Margin Trading
As much as we’d like it to be, margin trading isn’t without risks. Here’s a closer look:
Greater losses
Leverage is a double-edged sword. Just as it amplifies profits, it can increase the value of losses if the market moves against you. Let’s say the forex pair you’ve bought with margin rapidly declines in value. In such a situation, you would not only need to cover the initial equity investment but also additional capital.
So what can you do? Implement strict risk management strategies, such as stop-loss or take-profit orders.
Additional fees
Margin trading comes at a cost. Most brokers often charge interest expense and account fees. These fees are assessed and can vary depending on how well (or poorly) your margin account is performing.
Risk of margin calls
If the market does move against you, your broker can issue a margin call. You will be required to deposit additional funds to maintain the minimum balance requirement. This is also known as the maintenance margin.
Chances of forced liquidation
If a trade goes extremely poorly, you may need to sell your securities at a loss. This is known as forced liquidation and can result in a significant financial burden for a trader.
