Is Trading on Margin a Good Idea? (Risks Explained)

There is no doubt that in the game of investing the returns you get is dependent on the amount you put in, so the opportunity to leverage on a bigger investing capital is an appealing one. But is trading on margin a good idea?

Trading on margin is a good idea if you are aware of the risks and how to protect your investment, but it could be catastrophic if it leads you to risk more than you can cope with. Investing itself is a risky game, with or without margin.

Surely, you would like to know the advantages and disadvantages of trading on margin, but first, let’s find out what exactly is trading on margin.

Table of contents:

What Does Trading on Margin Mean?

Trading on margin means buying or selling an asset with only a part of the capital needed for that transaction, while the broker or the exchange takes care of the rest. In other words, you are borrowing money from the broker or the exchange to make up the amount needed for the trade.

Generally, in the stock market, the broker lends you the money required complete the trade, but in the futures market, it is the clearinghouse of the exchange that covers for that balance. To trade stocks on margin, you must open a margin account rather than the usual cash account.

In the US, the law requires that you open a margin account with a minimum of $2,000 and must provide at least 50% of the amount you intend to invest (initial margin). If the trade is making money, your part of the invested capital (trader’s equity) will be increasing, but if it’s losing money, your part will be decreasing. All through the life of the trade, your trader’s equity must not fall below 25% or whatever maintenance margin your broker chooses.

So, in other words, the initial margin is the amount you need to open the position, while the maintenance margin applies after you’ve entered the trade.

Day Trader Pattern Rule

One particular rule that applies to any trader with a margin account is the pattern day trader rule. In short, this rule imposes some limitations on margin accounts with less than $25 000. However, the day trader pattern rule only restricts daytrading activity, and will not be an issue if you’re looking to hold your positions overnight!

Here you can read more about the pattern day trader rule.

Let’s now have a look at the advantages of margin trading!

Advantages of Trading on Margin

As you can imagine, trading on margin can offer you a lot of benefits; these are some of them

1.Higher potential returns

When you are trading on margin, you are scaling up the size of your position in the market. In other words, you are leveraging on bigger position size. The initial margin and leverage have an inverse relationship. The lower your initial margin, the higher the leverage and the higher your potential return. So if your initial deposit is 50% of the total cost of a trade, you can make twice what you would have made on a cash account.

2.Diversification potentials

If you are trading on margin, you ca