Are you new to investing, or looking to explore more advanced investing options? Investing seems pretty straight forward. You buy an asset and hope that the price of that asset rises. In the modern financial world, however, there are a lot of nuances to investing. Margin accounts, for example, have emerged as a way for both investors and brokerage firms to earn some extra money.
So what is margin trading? The buying on margin definition essentially refers to a brokerage firm or other institution loaning a trader money to invest. Generally speaking, brokerage firms will allow you to trade a certain amount of your investment on margin. This means that if you invest $10,000 dollars in a stock, a firm might be willing to lend you a certain percentage of what you initially invested so that you can invest even more.
For example, a firm might extend you a margin of 50%, meaning you could invest an extra $5,000, or perhaps 100% so you could invest up to $20,000 in total. This is a lot more than $10,000 and if your intuition proves to be correct you will earn a lot more money. Of course, if your insight proves to be incorrect, you will end up losing more money.
When it comes to investing there are two general types of accounts. First, there are cash accounts where you can only invest your own money. Second, there are margin accounts where brokerage firms will extend you offers to essentially loan money to invest.
Brokerage firms make money off of fees and interest rates charged for the loan. Interest rates on margin loans are often higher than other types of loans, such as auto loans and house loans. That’s because the risks for both the lender and the lendee are much higher.
Why Use Margin Accounts?
A lot of investors don’t have huge amounts of cash on hand. While investing is often thought of as a rich person’s domain, many middle class families are now investing their money in order to secure their financial future.
Even as a small investor you might see a big opportunity in the market. For example, perhaps a company suffers a security breach and prices plummet. You might be familiar with this company and may recognize that the stock is being oversold. You feel more than confident that the stock will rebound.
You yourself might have $5,000 dollars to invest, but you’re so confident that you’d love to invest more. Luckily, you often can. By buying on margin you can borrow money, often 50%, from your broker to invest more.
Buying on Margin Is High Risk
Does opening up a margin account sound tempting? We certainly couldn’t blame you for wanting to get into margin trading, and as long as you are careful we encourage you to do so. Before you open a margin account, however, you need to understand that the risks are much higher.
When you take out a loan you have to pay it back. Your brokerage firm is going to make you pay back the money you borrow. If your margin investment turns out to be a winner paying back the money won’t be a problem. You’ll just have to liquidate some stock and pay off the loan. The profit you made off of the investment should be able to cover the interest rates too.
If you turn out to be wrong, however, you might find yourself losing a lot of money. You’ll have to pay back your loan, and also the interest. If it’s a big loss, say a 25% drop in stock prices, you could end up struggling to repay the loan. So make sure you’re careful when engaging in margin investing.