What Is Margin Stock Trading?
Stock traders use a brokerage margin account to increase the returns earned from the amount of capital invested. A margin account allows a trader to borrow a portion of the money used for stock trading. Using borrowed money to increase trading profit is called using leverage.
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Margin Accounts
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A margin account is one of the two basic types of brokerage accounts along with a cash account. You can get a margin account by completing the account application, reading and signing a margin account agreement and depositing the broker's minimum equity requirement for a margin account. The Securities and Exchange rules require a minimum of $2,000 trader equity in a margin account. Individual brokerage firms may set the minimum at a higher level.
Double Buying Power
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Margin account rules allow a trader to borrow up to half the cost of buying stock in the form of a margin loan. Put another way, a trader has what is referred to as two times buying power. Stocks worth up to two times the investor's equity in a margin account can be purchased. For example, a trader deposits $20,000 into a margin account. This level of equity allows the trader to purchase up to $40,000 worth of stock. Buying shares on margin leverages the trader's capital by a factor of two.
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Effects of Leverage
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Leverage multiplies the gains or losses a trader incurs while trading. Consider a trade for $10,000 worth of stock. If the stock goes up to $12,000 in value, the trader earned 20 percent. If instead, the trader used a margin loan to buy $20,000 worth of stock with the $10,000 equity, the stock increased 20 percent to $24,000. The trader earned $4,000 on her $10,000 of equity, a 40 percent gain. If the stock had declined by 20 percent, using margin would have increased the trader's loss to a 40 percent loss.
Margin Trading Considerations
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Shock short-selling is only allowed in a margin account. Selling a stock short involves borrowing shares from the broker, selling them short and buying them back at a lower price, profiting from the falling share price. Another important factor in a margin account is the maintenance margin limit. The maintenance margin is the minimum amount of trader equity the brokerage firm will allow. It the trader's equity falls below the maintenance margin percentage -- at least 25 percent by SEC rules -- the trader must deposit more cash or sell stocks to pay down the margin loan.
Day-Trading on Margin
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Day-trading involves buying stocks and owning them for less than one day, profiting from small price changes during the market day. A margin account designated as a day-trading account has special margin rules. A trader with a day-trading account must maintain at least $25,000 in trader equity. On the other side, a day-trading account is allowed up to four times buying power when day-trading. A trader with $50,000 in his account could own up to $200,000 worth of stock during the market day with the four times leverage.
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References
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