What Is Margin Trading? Advantages, Disadvantages, Risks, Costs, and Mechanisms

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Simran Kaur
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Margin Trading

Margin transactions are transactions in which you borrow cash or stock certificates from a securities company and use cash or securities you own as collateral. It is characterized by the ability to trade for more than the amount pledged. Today, we will explain how stock margin trading works, its advantages and disadvantages, etc.

What is Margin Trading?

Margin trading is a method of trading assets using funds borrowed from a broker. In simple words, transactions in which you can buy and sell stocks by borrowing cash or stock certificates from the securities company by depositing cash or securities you own (stocks, etc.) to the securities company as a security deposit. It is common to open a margin trading account at a securities company and conduct transactions.

Margin Trading Mechanisms:-

Margin trading consists of two mechanisms: buy (margin buying) and short (margin selling). Let’s understand this-

Buy Mechanism:

Buying stocks involves borrowing cash from a securities company to buy stocks using a security deposit as collateral, and the purchased stock certificates are called buying positions. Spot trading, where you trade stocks using only your own funds, starts with a buy, so the basic mechanism is the same as a buy order in spot trading. Margin buying differs from spot trading in that it allows you to trade by borrowing cash from a securities company that exceeds your security deposit, so you can trade with more than your own funds. In addition, since margin purchases involve borrowing cash for transactions, the cash must be repaid by the due date. There are two ways to repay the loan: sell the stocks you bought on margin and use them to fund the repayment (resale), or prepare the borrowed funds yourself and repay the loan (cash).

Sale Mechanism:

Selling involves borrowing shares for sale from a securities company using a security deposit as collateral, and then selling those shares. Stocks that are sold are called sale positions. A feature of margin trading is that you can start trading with a sell order even if you don’t have the stocks in hand. There are two ways to repay stocks borrowed from a securities company: You can purchase stocks of the same brand sold on margin and use them to repay the stock (buyback), and you can prepare stocks of the same brand yourself as the borrowed stocks and repay them as second methods (current delivery).

Advantages of Margin Trading:-

We will introduce the main advantages of stock trading using margin trading rather than spot trading.

Trade with leverage:

 When starting a new margin transaction, the deposit that must be submitted to the securities company as collateral is 30% or more of the contract amount. You will be able to trade at a maximum of approximately 3.3 times the security deposit. In spot trading, you can only trade at 1:1, but a major feature of margin trading is that you can trade with leverage (investing a large amount of money with a small amount of money). For example, if you put down a deposit of 300,000, you can trade up to 1 million. If you trade with leverage, the profit amount will be larger when you make a profit. Another advantage of margin trading is that it makes it easier to get into high-value stocks, which you cannot buy with your own funds.

Investment opportunities even during downturns:

Another advantage of margin trading is that there is an opportunity to invest during periods of declining stock prices. In spot trading, you cannot sell stocks that you do not own, only through buy orders. In that respect, margin trading is called margin selling, and you can start trading with a sell order. Margin selling is also called short selling because it involves placing a sell order without owning the stock . The reason why short selling is possible is that, as explained in the margin trading mechanism, you can borrow stock certificates of stocks held by securities companies from securities companies. With margin trading, you can start trading even from a short position, so you can get investment opportunities by selling short even when stock prices are declining. In addition, by taking advantage of the ability to sell on margin, if the stock price of a stock you actually own is likely to fall but you do not want to sell it, you can sell the same stock on margin to hedge your risk and cushion the shock of the stock price decline. You can also expect good results.

Trade using stocks as collateral:

Margin trading requires depositing a security deposit with a securities company as collateral, but deposits other than cash are also accepted. In spot transactions, the securities you own can also be used as security deposits, and the feature is that not only the stocks you own, but also investment trusts can be used as collateral. For example, stocks held in spot transactions for the purpose of shareholder benefits or dividends can be effectively utilized by posting them as security deposits in margin transactions. In addition, held stocks, etc. that are pledged as security deposits are also called substitute securities. However, when substituting securities are offered, the appraised value is calculated by multiplying the market value by a certain rate (multiplier) determined by each securities company depending on the type and issue of the securities. It is important to understand that the market value does not directly reflect the valuation value.

Buy and sell the same stock multiple times on the same day:

There was a rule in margin trading that the deposit deposited with the securities company could not be reused until the delivery date after settlement. However, since January 2013, regulations have been relaxed to allow unlimited trading within the margin, making it possible to trade within the same margin. Rotational trading is the process of repeatedly buying and selling the same stock over a short holding period using the same margin. With margin trading, there are no restrictions on buying or selling the same issue, so you can buy and sell the same issue multiple times in a day using the same margin.

Disadvantages of Margin Trading:-

We will discuss four disadvantages that you should be aware of when trading on margin.

More expensive:

There are multiple fees in margin trading, which make it expensive. Margin trading involves borrowing cash or stock certificates from a securities company, so in addition to transaction fees, there are costs such as interest rates incurred when borrowing cash and stock lending fees incurred when borrowing stock certificates. .

Losses are likely to increase:

We explained that the advantage of margin trading is that you can trade with leverage. When it works positively against the market, there is a possibility that you can make a bigger profit than spot trading, but when it works against the market, the opposite is possible. Therefore, there is also the possibility of incurring large losses. In the case of spot trading, even if you incur a loss in stock trading, the value will not drop to 0 yen unless the company you own goes bankrupt. On the other hand, margin trading allows you to trade at a maximum of approximately 3.3 times, so if the loss is large, the margin deposit may not only become zero but also become negative. If the market fluctuates significantly, your losses will increase significantly, so you need to take measures such as controlling your risk by cutting your losses .

Risk of margin call:

Margin trading involves the risk of margin calls. Margin means that if the margin line (minimum margin maintenance rate) determined by the securities company falls below, an additional margin deposit will be required. For example, if the margin line is 25%, a margin call will be required if the margin deposit for the issue held on margin falls below 25%. Margin calls occur when unrealized losses on open interest increase, or when stocks held in spot trading are pledged as margin and the value of the stock falls.

Risk of forced liquidation:

Forced settlement may be performed at the securities company’s discretion if no additional margin deposit is received despite a margin call, or if payment is not made by the repayment date. When forced liquidation occurs, settlement occurs at a time that investors do not intend. Care must be taken as unexpected losses may occur.

Margin Trading Costs

Margin trading incurs costs such as interest rates and stock lending fees in addition to trading fees (margin trading fees). Let’s take a closer look at what happens in each case.

  • Buying and selling fees: Trading fees are fees charged for both margin buying and margin selling. Although it differs depending on the securities company, trading commissions, etc.

  • Interest rate: This is the cost incurred for borrowing money from a securities company. This occurs when you borrow money from a securities company to buy stocks through margin trading.

  • Stock lending fee: This is the cost incurred when borrowing stock certificates from a securities company for margin trading. You will need it when selling on credit.

FAQs:-

  1. What is margin trading and how does it work?
    • Margin trading involves borrowing funds from a broker to trade assets, leveraging your investments for potentially higher returns.
  2. What are the advantages of margin trading?
    • Advantages include trading with leverage, investing during market downturns, using stocks as collateral, and executing multiple trades in a single day.
  3. What are the disadvantages of margin trading?
    • Disadvantages include higher costs, increased risk of losses, margin calls, and forced liquidation by the broker.
  4. How does leverage work in margin trading?
    • Leverage allows traders to control larger positions with a smaller amount of capital, amplifying both gains and losses.
  5. What fees are associated with margin trading?
    • Margin trading costs include trading fees, interest rates on borrowed funds, and stock lending fees for borrowing securities.
  6. What is a margin call?
    • A margin call occurs when the margin balance falls below the minimum maintenance level set by the broker, requiring additional funds to be deposited to cover losses.
  7. What is forced liquidation in margin trading?
    • Forced liquidation happens when a broker sells off a trader’s assets to cover losses if margin calls are not met or debts are not repaid.
  8. How can traders manage the risks of margin trading?
    • Risks can be managed by setting stop-loss orders, diversifying investments, and maintaining sufficient margin levels to avoid margin calls.
  9. Is margin trading suitable for beginners?
    • Margin trading is risky and may not be suitable for beginners due to the potential for significant losses.
  10. What precautions should traders take before engaging in margin trading?
    • Traders should thoroughly understand the risks, have a solid trading strategy, and ensure they have sufficient knowledge and experience before venturing into margin trading.

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