Trading on margin involves borrowing money from a broker to buy securities. A margin account increases your purchasing power and allows experienced traders to improve their investment’s performance. Margin trading offers higher profit potential than traditional trading, but also comes with risks. In this article we’ll discuss how to use margin trading to your advantage as you seek to diversify your investment portfolio.

 

The Difference Between Cash Account and Margin Account

 

Before investing, it’s important to weigh the risks and advantages of trading in a margin account relative to a cash account. On one hand, with cash accounts, you buy assets with the amount you have. On the other hand, a margin account allows you to borrow money from a broker to buy more assets, this increases your buying power, assuming that the value of your investment goes up.  But if there’s a sharp decline, you could be losing more than the total value of your account.  Before discussing the risks, let’s first look at the key advantages of using margin.

The Opportunity to Leverage Assets

 

Whether you have been trading for a few months or years, you’ve probably at some point wished that you had more money to trade with. A margin trading account offers you just that.

A 50% margin allows you to buy up to twice as many securities as you could with just your own cash. The ability to buy up to twice as many shares in a cash account opens up new investment opportunities that otherwise would be much harder to achieve. This allows you to potentially amplify your returns, assuming the value of your investment goes up.

 

The Ability to Diversify a Concentrated Portfolio

 

Trading can be risky, we get it. But one way to manage that risk is through portfolio diversification.  It’s that old cliché: ‘Don’t put all your eggs in one basket.   When your portfolio is concentrated on only one thing, you are placing a lot of reliance on that one investment, which puts you at significant risk.

A Margin account, on the other hand, allows you to borrow against securities you already own, freeing up cash to buy securities with collateral without having to close any of your existing positions.

The Flexibility of Margin Loan Repayment Schedules

 

Unlike most other forms of debt, margin loans generally don’t have a fixed repayment schedule. You can pay your debt anytime, as long as you maintain collateral limits in your account. Of course, your margin account will continue to accrue monthly interest charges, but the current cash or securities in your account will serve as a collateral for a loan.

Where There’s A Higher Reward, There’s A Higher Risk

While margin loans offer many benefits, they are by no means risk free.

Increased potential returns on investment usually go together with increased risk. And like any type of loan, margin borrowing comes with different types of risks. Just as using margin to invest can amplify your potential returns, it can also multiply your losses if the value of your investment goes down. If you have a margin loan and your investments drop down dramatically, you’ll have to pay interest on the margin loan.

Additionally, you’re always required to maintain a minimum level of equity of a margin account; usually about 30 to 35% of most assets. If your securities should start to drop in value – and fall below this level – you’ll need to deposit additional cash into your account.

 

 

How To Manage Margin Account Risk

• Consider leaving a cash cushion in your margin account to protect you against a sudden drop in the value of your loan collateral.
• Consider setting up alerts to notify you when the value of your investment drops dramatically.
• Invest in assets with high return potential; the stocks you buy on margin should, at least, have the potential to earn more than the interest rate on the loan.
• Pay interest regularly; monthly interest charges are accrued to your account, so it’s important to pay interest down before it builds up.