Dec

What Is Margin Trading And How Does It Work?

By emily

I love investing in the stock market, but margin trading can be a little bit risky. In a nutshell, margin trading means buying stocks with borrowed money. It’s what contributed, in part to the big stock market crash of 1929 that predated the Great Depression. That’s not to say that margin trading is going to send us into another tailspin, but it’s important to keep track of what you are doing and err on the side of caution when making big bets.

What Is Margin Trading In The Stock Market?

Margin trading, and the workings of the stock market in general, is a mystery to the common public. Most can’t figure out one column of figures from the next, and econonmic theory goes right over their heads. Even when explained to in the simplest terms, people still can’t make heads or tails of margin trading and how one would go about doing it.

The most important thing to understand about margin trading, then, is that your stake in your purchase – be it in shares, bonds or securities – has to end up above a net value. If you borrow $80 from a broker on a $100 share, and the broker wants a minimum requirement of $10, you have to always keep your stake at $10 or above. If you don’t, you’ll be in default on the loan.

So it’s important to understand is that margin trading means you’re borrowing large sums of money from a broker in order trade. And that if you lose said large sum of money, you’re on the hook for your own loss as well as the loss of the broker. Obviously this won’t work out very well for you if you’re on the losing end of a market run. However, what should be readily apparent is that it’ll work out for the broker no matter what the market does.

Say the market is bullish and the value of your purchased securities goes up… the broker wins! He gets his fee from you and maybe something extra as determined by the loan conditions. Everyone’s rich, everyone’s happy, no big worries.

But say the market goes down – and it’s gone down significantly and often over the years. You’re on the hook for what you’ve lost, but now you’ve also got to pay off the broker. His cut won’t be as large as it would have been had the market gone up, of course, but he’s still making a profit because you’ve paid him in the first place to borrow the money no matter what the market does. This is called a “margin call,” and it means that you’ve got to pay the broker back right then or else you risk bankruptcy or worse.

This causes a volatile market, much like we’ve seen recently in the housing boom and bust, and much like we saw in the 1920s when margin trading nearly brought the western economy to its knees.

Share and Enjoy: