Margin trading how does work

You are allowed to buy stocks by paying a marginal amount of the actual value. This margin is paid either in cash or in shares as security. Margin trading can be considered leveraging positions in the market either with cash or security by investors. Your broker funds your margin trading transactions. The margin can be settled later when you square off your position. You make a profit when the profit earned is much higher than the margin, else you suffer a loss.

Until last year, the margin trading was allowed only with cash and providing shares as collateral was not allowed. However, the longer your margin loan remains unpaid, the more you'll want to consider how interest costs could impact your returns. While it may seem that margin trading means bigger profits, that's not technically true.

In fact, you'll have slightly less money at the end than if you had bought the stock outright since you'll have to pay interest on the borrowed amount. Using leverage to increase investment size, as margin trading does, is a two-edged sword. On one hand, it can significantly increase your rate of return. But losses can also multiply fast. There's another risk: A decline in your investments can lead to an account falling below the broker's maintenance margin the minimum balance, in either cash or securities, that you're required to keep in the account.

When this happens, the broker will issue a margin call. A margin call is your broker basically demanding or "calling in" part of your loan. A margin call requires more funds to be added to your account to bring its balance back above the minimum requirements.

If you can't promptly meet the margin call, your broker has the right to sell some of your securities to bring your account back up to the margin minimum. What's more, your broker does not need your consent to sell your securities.

In fact, they may not be required even to make a margin call beforehand. The potential for a margin call and the involuntary sale of assets makes trading on margin riskier than other forms of financing. With a mortgage , for instance, your lender can't foreclose on your home just because its appraised value has gone down. As long as you continue to make your mortgage payments, you get to keep your home and can wait to sell until the real estate market rebounds.

But with margin trading, you can't always just wait out dips in the stock market. If the stock price falls and your equity dips below the minimum margin trading requirement, you'll need to add more capital or risk having some of your securities sold at a serious loss.

Your equity percentage, or ownership stake in the company, is calculated by dividing the current value of your securities by your debt. But brokerages are free to set higher minimums. However, this does not influence our evaluations.

Our opinions are our own. Here is a list of our partners and here's how we make money. The investing information provided on this page is for educational purposes only. NerdWallet does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks or securities. The most common way to buy stocks is to transfer money from your bank account to your brokerage account , then use that cash to buy stocks or mutual funds, bonds and other securities.

Margin trading is a form of leverage, which investors use to magnify their returns. Margin accounts vs. Even though she has to return the borrowed money, she gets to keep the gains it helped her achieve. By trading on margin, the investor doubled her profit with the same amount of cash. Not every investment is a winner, however.

You read that right. As the example above illustrates, margin trading can be risky and pricey business for investors without the know-how and financial means to handle the loan. Like a secured loan, a margin loan requires the investor to provide collateral, which acts like a security deposit.

Footnote 1. To purchase a stock on margin, you first need to open a margin account. That's different from a typical brokerage cash account, although many brokerages will give you margin accounts automatically, unless you specifically tell them not to.

Brokerages can set different minimum account balances, margins and maintenance minimums, as long as they are more stringent than the federal rules.

The mechanics of buying on margin run as follows. Not all securities are marginable. In general, penny stocks, over-the-counter Bulletin Board OTCBB securities or initial public offerings IPOs cannot be purchased on margin, and different brokerages have different restrictions.

What's more, brokerages may set maintenance minimums to correspond with the volatility of a stock. Our lucky Apple investor, flush with his recent success, next decides to buy two different stocks on margin.

Proceeds of the sale are used in part to pay off the loan, but still leave him with a tidy profit even after trade commissions and interest expense on the loan are factored in. His second purchase takes a different tack. The two transactions taken together might at first appear to be a wash, but when commissions and interest on the loans are factored in, he winds up in the red. What's more, if our investor had only executed the second losing transaction, he could have triggered a margin call, forcing him to sell other investments to meet maintenance minimums.

The takeaway here is that margin accounts are risky. They should be used in moderation, for limited positions, and for short time periods only — because even the pros are not good at guessing the market over time.

Footnote 1 Borrowing on margin may not be appropriate for every investor. An investment strategy that includes trading on margin exposes investors to additional costs, increased risks, and potential losses in excess of the amount deposited. Carefully review your investment objectives, financial resources, and risk tolerance to determine whether it is right for you. No one should buy on margin without the temperament to accept the price fluctuations that are intrinsic to the marketplace, and the financial resources to meet margin calls and absorb trading losses.

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