Thursday, January 16, 2014

How Does Buying Stock on Margin Work?

Most investors these days are woefully unprepared for the intricacies of diving head first into the global stock market, and so may not understand the concept of buying stock on margin. Simply stated, buying on margin is taking out a loan to purchase securities. Sound dangerous? It can be if you’re not careful!

Although there is a ton of money to be made there relatively easily, many investors believe that there’s nothing to it - you just pick a few of your favorite companies, buy the stock, and watch it grow. Unfortunately, nothing could be further from the truth. If you ever want to see any sort of return on your self-guided investments, you have to become intimately acquainted with at least the basics of how the stock market works. Now, that being said, there are tens of millions of people out there who make a dedicated hobby of the stock market, and they generally don’t do too bad, financially speaking. There are also tens of thousands of people out there who make a VERY comfortable living working over the intricacies of the market.

Unfortunately, there are also a large number of investors who, thinking that they know a little bit about the stock market, get in too deep and lose substantial amounts of cash- quickly. Buying on margin is one of those advanced stock market terms that neophytes in the world of securities trading might hear on the wind, but may not necessarily understand. Perhaps you’ve heard that you can make substantially larger investment gains on margin than you can on standard trading, and that isn’t too far from the truth. However, there is a downside.

First off, margin trading is not for newbies. It’s as simple as that. Ask any professional financial advisor, and they’ll tell you that unless you’ve been swimming in the great stock market pond for a few years, it’s best to leave margin trading to the big fish, and here’s why: You might see some phenomenal increases in stock value while trading on margin, but what goes up, can quickly come down. Sure, margin amplifies your positive stock returns, but it can also amplify your negative returns, and it can get really ugly really quickly. You need to be able to stomach those downturns in the market, or else be smart enough to stay on top of the market’s movements so you can mitigate any potentially disastrous losses.

The Day Trading Connection

Margin and day trading practically go hand in hand. Without it, attempting to trade at a faster pace than once per week without sufficient funds in your investment account is known as “freeriding.” It happens when an investor attempts to perform a trade before the funds from a sale have cleared to the account. For example, let’s say you have $100 worth of equities in your account. You buy $100 worth of stock on Monday, but the price rises on Wednesday morning, so you try to sell so you can get in on the profit. Trouble is, you can’t. That would be freeriding. The money from the purchase of the stock won’t have cleared yet, so you can’t sell (because it hasn’t been paid for yet.) It works out to about four days worth of waiting for the money to clear. For instance, you might make a trade on Monday, and the funds won’t clear until Thursday.
Margin trading does away with this limitation when used wisely. For most investors (particularly day traders,) margin is essentially an extension of credit that can be used to perform trades on a day to day basis while still having enough in your account to cover any quick trades you might wish to make. It would be like having $100 of your money in the account, and $100 of credit (though the amount varies considerably.) so that you can use all $100 for investment rather than the $50 you would have had to use before to cover the sale and purchase of the stock. 

As an investor, you’ll have to apply with your brokerage company to open a margin trading account, because you won’t be able to trade in that fashion without clearance. The account itself is treated just a little differently. Check out a later post when we’ll go over how to actually make trades when you have a margin account. Until then, happy trading!

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