The term 'Margin Trading' is included in the Investments edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Margin trading is the practice of buying investments on margin. This is accomplished through borrowing money from your broker in order to buy stocks. Another way of understanding margin trading is taking out a loan from your broker to buy greater amounts of stock shares.
Margin trading generally requires a margin account. Margin accounts differ from cash accounts that only allow you to trade with the money that your account contains. Brokers have to get a signature from you in order to open up a new margin account. This could be as an extension of your existing account and account opening forms or as a separate and new agreement. Minimum investments of $2,000 are necessary to open such a margin account. Some brokers insist on larger amounts. Whatever the final margin requirement deposit is, it is called the minimum margin.
After the margin account is up and running, you are able to purchase as much as fifty percent of a stock with margin trading money. The money that you use to buy your part of the stock is called initial margin. Margining up to the full fifty percent is entirely optional. You might borrow only fifteen or twenty percent instead.
Margin trading loans can be held for as long a period as you wish, assuming that you continue to meet the margin obligations. A stock maintenance margin has to be maintained while the loan is outstanding too. This maintenance margin is the lowest account balance that can be held by the account in advance of the broker making you deposit additional funds. If you do not meet this minimum or resulting margin call for extra funds, then the broker has the right to sell your stocks in order to reduce your outstanding loan.
Borrowing money from your broker is not done for the sake of charity. Interest has to be paid on the loan. Also, the marginable securities in the account become tied up as collateral. Unless you pay down the loan, interest charges will be applied to the loan balance. These interest amounts can significantly increase the debt level in the account with time. Higher debt levels in your account lead to still higher interest charges. Because of this, buying stocks on margin is typically utilized only for shorter time frame investments. This is true since the greater amount of time that you hold the margin loan in the investment, the higher a return you will require in order to break even on the margin trade. When you maintain such a margin based investment over a long time frame, it becomes difficult to turn a profit after the expenses are cleared.
It is also important to remember that not every stock qualifies for purchase using margin. The rules pertaining to which stocks can be purchased with margin are set by the Federal Reserve Board. In general though, Initial Public Offerings, penny stocks, or over the counter traded stocks are not allowed to be purchased utilizing margin as a result of the daily volatility and trading risks associated with such kinds of stocks. Besides this, each brokerage can restrict whichever other stocks that they wish.