Margin Trading 101: How It Works
What is margin trading? What is a margin? What is the difference between a cash account and a margin account? In episode #34 of Real World Finance we dive deep into answering these questions! If you are new to trading, don't worry, this video is right up your alley!
So if you’re still with me, lets dive a little deeper, and examine how exactly margin accounts work. So the first step is discovering what leverage ratios your broker will offer you. Some brokerages offer a 1:1 Ratio, some offer a 3 or even 4:1 Ratio, and these ratios vary. In fact in the world of forex trading, it is not uncommon for a brokerage to offer its customers a 1 or 200:1 ratio. All the leverage ratio represents is, how many dollars your broker is willing to loan you for every 1 dollar that you deposit into your account. So if you deposited $10,000 a 1:1 ratio would mean that your broker would loan you an additional $10,000, while a 3:1 ratio would mean that your broker would be willing to loan you an additional $30,000. So the first step is to discover what leverage ratio your broker is willing to offer you. For the sake of simplicity we are going to continue with the 1:1 leverage ratio that we used earlier.
So you now have $10,000 of your money, and another $10,000 loaned to you on margin by your broker. The next thing to consider is the margin rate. Like with any loan, the lender expects to be paid interest by the borrower. When trading on margin this interest rate owed to the brokerage is called the “Margin Rate”. So keep in mind that whether you win or lose on an investment, you will still owe interest, because you are using your broker’s money.
So next, let’s talk about the rewards that can come from making a good investment while trading on margin. If you experienced a $1,000 return on your $10,000 then you would have experienced a 10% return. But when margin trading if you experience a $1,000 return on your 10 grand and another $1,000 return on your borrowed 10 Grand, then you have realized a return of $2,000! After giving back the borrowed $10,000 you now have made $2,000 on your personal $10,000 investment, meaning that you realized a 20% return instead of the standard 10%. This is the true power of margin trading. You unlock the potential for amazing gains.
But let’s talk about the dark side of margin trading. What happens when you make a bad investment, or the market crashes? Once your investment begin to fall in value, it is only a matter of time before it breaks through your broker’s risk tolerance levels and triggers something known as a margin call. This is not a situation that you want to find yourself in! Essentially, your broker will send you a message or call you up and say, you need to put x amount of dollars into your account to cover this increasing risk! If you do not have the money to deposit then they can and will begin selling off your investments at a loss, in an attempt to get their money back. Whatever they can’t get back, you will now owe them, in addition to all of the interest that you have accrued on the loan they gave you. But you don’t have any money to give them, all of your money just disappeared for good when the broker sold off your investments, so what do you do? How do you get the money to pay them off? This is a nightmare situation and somewhere that you NEVER want to find yourself in! So if you do decide to begin margin trading, you need to respect the market and stay conscious of the fact that you are now gambling with someone else’s money.