Margin Trading

Whether or not you know what the financial term margin means, you may never reach the point where you can decisively say if it's good or bad. Even those who have been investing for years are heavily divided on this issue.

By definition, margin is investing with borrowed money. A margin account lets a person borrow money from a broker to purchase securities at a fixed interest rate on the condition, that 50% of the amount invested is the investors equity.

For instance, if you wanted to purchase $10,000 worth of stock on margin, you would have to provide at least $5,000 of the cash. The broker will loan you the difference. And the difference between the amount of the loan and the price of the security, is called the margin.

Using this leverage, you can make twice as much money on a successful investment as you could otherwise. But as enticing as this may be, the drawbacks are equally impressive.

The most important point to realize is that you will be charged interest for borrowing the money. This means that if you make 15% on your investment in a year's time and you have to pay say, 8% in interest, you have to cut your profit down substancially.

It's more desirable for margin investors to pick short-term trades in order to "hold" the money for a very short time, and having to pay little interest on it. But short-term estimates on market performance are often difficult to correctly anticipate, and hence risky.

Another drawback (which is the main reason for the dislike among some investors for margin) is that the securities in your account can and will be sold if the price of your security goes in the opposite direction far enough, i.e. you making losses.

For instance, since you are required to keep a certain amount of equity in your account, if the value of your investment falls, your broker may make a margin call.
This means that you will be required to put additional capital/cash into your account or the broker will sell as much of your investment as necessary to retrieve the money that was lent to you.

This means you will be forced to sell at precisely the time it is most damaging to do so.

In some extreme cases, margins caused serious economic troubles. During the great depression era which started with the big stock market crash of 1929, it was only required that investors put up 10% of the amount of the margin loan. If someone wanted to buy $10,000 worth of stock, they were only be required to deposit $1,000 upfront.

This wasn't a problem until the market crashed, causing stock prices to fall. When brokers made their margin calls, they found that no one could repay them since most of their wealth was in the stock market, thus, the brokers sold the stock to pay back the margin loans. This created a downward chain-reaction until prices eventually were battered down and the entire market demolished.

Knowing all this, is it wise to use margin? Only on short-term if you are fairly confident about the short-term moves of the market, and strictly adhering to money management rules.

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