The risks of margin trading for new traders is high. But, high risk also has higher return. If yes, did it sound appealing to you? So just how do you minimise the risk and maximise the upside.
This article is for those who are interested in knowing what margin trading is and the risks of investing in stocks on margin.
Get comfy and beware of the waves.
What is margin trading?
Essentially, margin trading is borrowing an amount of money at a lower interest rate from the broker to buy stocks that might leverage your profit. To put in a few words, trading with borrowed money.
This kind of trading is for those who want to bit more than they can chew. Margin traders can get really aggressive and buy more shares than their funds allow.
This whole process is just like a contract with your broker – they borrow money at lower rates and lend this money to you at slightly higher rates. This money will work as extra funds so that you buy stocks that you wouldn’t be able to buy otherwise.
Risks of Margin Trading For New Traders IS HIGH – BUT SO IS THE UPSIDE. HOW DO YOU MINIMISE RISK AND MAXIMISE UPSIDE?
Margin trading is only available for people who already have a specific amount of money in their brokerage account – all the assets they own in the same account are their collaterals, a.k.a. personal guarantee, for when they need to repay their debt to the broker.
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What are the risks of margin trading?
Investing in stocks on margin is one of the reasons why many people believe trading is gambling – it’s an inherently speculative type of trading in which the chances of losing money are similar to the chances of earning money.
You can earn a lot of money and have the usual thrill we only feel on first dates, but you can also lose a lot of money and have the usual sadness that appears in a long-term relationship break-up.
For example, let’s imagine you have £5,000 in your brokerage account and you’re interested in buying a £10,000 share.
You don’t have this kind of money right now, but you see an opportunity for profit, and you’re an aggressive and experienced trader. You risk borrowing extra £5,000 from the broker.
Now you’ve entered the mystic realm of margin trading, where anything can happen.
Let’s think of 2 scenarios:
1 – Good news. The stock price is up and running, now you can sell it for £11,000! That means you are getting your initial £5,000 back, you’ll pay the broker the £5,000 you borrowed + the super-low interest.
In this case, your profit will be of almost £1,000! Way to go.
2 – Bad news. The stock price fell drastically, and you could only sell it for £9,000. In this case, you’ll still need to pay the £5,000 to the broker + interest, which means you’ll only get back 4,000.
Be aware that you can lose more money than you invested in the first place. In the example, there is also a possible scenario where the total stock price falls from £10,000 to £1,000, for example.
If that happens, you won’t only be able to get your original investment of £5,000 – you’ll also not be able to pay back the borrowed £5,000!
What happens if I lose?
The money you can win or lose is limitless. That can be enticing for some people, but you must always remember that part of the money isn’t yours!
If your account blows up in case of a massive loss, and if you can’t afford to pay the money, the broker will put you on the hook for it.
They can haul you to the court and destroy your credit rating, just like any other company.
Margin trading is extremely risky, and I can’t stress this enough.
Don’t fall for the risks of margin trading as a new trader
Don’t risk margin trading if you can’t afford to pay the loss you might have. It’s like choosing to have a baby. If you’ve been there, you know it’s a type of decision to be taken after a lot of thought and financial planning – unless if your baby arrived unannounced.
Be conscious that, when you choose to start margin trading, all the assets on your portfolio are held as collateral, and the broker has complete access to them in case you don’t pay back the borrowed money + interests.
Yes, margin trading amplifies the performance of a portfolio, allowing traders to have more significant losses or gains that they could have had with only the available funds. However, don’t ever think that just because the price of a stock is undervalued that it can’t fall even more.
Speculating is for those who are very experienced in trading, and margin trading is for few.
If you still want to buy stocks on margin, understand the consequences and do it wisely. First, trade with your own beloved money for some time.
What do you think of margin trading? Have you ever tried to do it?
Share your experience and thoughts with us in the comment section below!