Margin Trading Account - Risks And Benefits

A Margin Trading Account at an online brokerage firm has the same capabilities of a cash account, plus some additional features. Understanding the risks and benefits are a must for any successful trader.

To open this type of account, you must submit a separate account application and it must be approved just like a loan application.

Once approved, the account acts similar to an equity line as you no longer have to get approval each time to trade using margin, just initially when you open the account.

You also have to have a minimum account balance of $2,000 to be approved for margin trading.

An additional type of account that you can test trading strategies with zero risk is a Simulated Trading Account.

Having a margin trading account enables you to borrow money from your online broker to place trades, just as you would a loan from your bank. There are limits to the amount you can borrow, of course, based on certain percentage multiples of your account balance.

You are basically able to purchase stocks on credit, while paying interest on the amount borrowed. Each online broker has different interest rates so be sure to check what the rates for your broker are ahead of time.

Another benefit of this type of trading account is that it enables you to place orders for additional trades before the funds from previous trades have cleared, as long as funds are still available based on your total purchasing power. This is possible because of your ability to borrow money as stated above.

Having a margin account also enables you to be able to short stocks. Shorting stocks is covered in more detail here, but it is basically the process of trying to profit from a decline in a stock price.

Using margin can also be used to increase the leverage of your account, meaning it enables you to trade with more money than you normally would be able to in a cash account due to the amount you can borrow. A standard margin account has two times the account value in purchasing power.

If you are classified as a "pattern day trader", your margin trading account will have four times the account value in purchasing power. A pattern day trader is also required to keep a minimum account balance of $25,000.

With a standard margin trading account, having an account balance of $10,000 you can now trade using $20,000. A 10% profit on $20,000 would produce a gain of $2,000. Since you only used $10,000 of your money, you now made 20% on your investment instead of 10%.

While this can be a great advantage, margin trading can also have disadvantages.

Consider the following example of benefiting from leverage:

  • Say you have an account balance of $10,000 to start with; in a cash account you place a trade with $10,000 and make 10%, or $1,000 on a trade. You risked $10,000 to make a 10% profit, or $1,000.

With a margin account you can use $5,000 of your own money, borrow the other $5,000 on margin, and still make $1,000 while only risking $5,000. You made the same total amount profit and percentage on the account balance, while risking less of your own money.

Now consider the following examples of margin trading being a disadvantage:

  • Say you have an account balance of $10,000 to start with: in your margin account you place a trade using your $10,000 plus $10,000 on margin; you close your position and lose 10% on the trade, or $2,000; Since you only had $10,000 of your money invested and you lost $2,000..... you actually lost 20% on the trade!
  • Consider the "gambler", pattern day trader who uses four times his purchasing power; he uses four times the amount and therefore loses four times the amount, or 40% of his money in our example.

As in other types of trading accounts, if you go over your limits of available funds, your account may be placed on restriction from trading. I have seen accounts placed on restriction for 90 day periods on more than one occasion.

In conclusion, a margin account used for buying stocks or shorting stocks, can be a very beneficial resource at your disposal. Some traders have several types of online trading accounts and use each one for different types of trades.

Always keep in mind that there are risks involved with margin trading and to be aware of them at all times. As always, to be successful at trading, you must educate yourself, develop a good trading plan and stick to the plan at all times.

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