How to Trade Stocks on Margin Part 1

David Waring · 10-21-2008, 12:33 PM

How to Trade Stocks on Margin (Part 1)

In our last lesson we finished up our module on how to place stock trades, with a look at how traders protect their profits, through the use of something known as a trailing stop. In this lesson we are going to start a new module with a look at trading stocks on margin.

Like the concept of short selling, trading on margin is one of the more confusing concepts that traders encounter, regarding the logistics of trading. Trading on margin, very simply involves the use of money borrowed from a trader's broker, which increases buying power and allows traders to amplify both their profits and losses.

To help understand the concept of margin, lets start with an example that many people are more familiar with, getting a mortgage to buy an apartment. For this example lets say there are two people who are buying apartments in the same building, each of which costs $100,000. The first buyer in our example pays the full $100,000 purchase price in cash. The second person does not have the full $100,000, so instead he puts down $20,000 of the purchase price, and obtains the rest of the $100,000 cost of the apartment by obtaining a loan for $80,000 from his local bank.

Next lets say that over the course of the next year, the price of both apartment goes up by $5000 to $105,000. While both of the people in our example have a $5,000 gain on their apartment, the percentage return on their money is quite different. For the buyer who put up the full $100,000 purchase price, the $5,000 increase in the value of the property represents a 5% gain on his money (5,000/100,000 = 5%). For the buyer who put up only $20,000 however that same $5,000 increase in the value of the property represents a 25% gain on his money (5,000/20,000 = 25%).

Now that we understand this, we can see that the reason why some traders choose to trade on margin is to try and amplify the gains on their capital when trading, in exactly the same manner as I have outlined above with the two apartments. While the ability to amplify one's gains through the use of borrowed money is certainly an advantage, it is also important to understand that trading on margin is a sword that cuts both ways. In other words just as the use of margin amplifies the gain, as you can see using the above example if the price goes down by $5,000 instead, losses are amplified as well.

So to take a stock trading example, lets say that we have two traders each who buy 100 shares of a stock which is trading at $10 per share. The first trader trades on an account without the right to use margin, which is known as a cash account, so he needs the entire $10,000 purchase price of the stock available in his account in order to buy this stock. The second trader, trades on an account with the right to use margin, which is known as a margin account. This trader is able to borrow up to 50% of the purchase price of the stock, so he only needs to have $5,000 in his account in order to purchase the same $10,000 worth of stock.

If the price of the stock trades up from $10 to $11, then both traders have a gain of $1 per share on their 100 shares for a total gain of $100. While this however represents a 1% gain on the first traders cash account (100/10,000 = 1%) it represents double the return, or a 2% gain on the second traders margin account (100/5000 = 2%). To simplify the example here I have not included commission costs or the cost of the interest traders pay on margin positions, which we will cover in coming lessons. Also, keep in mind here that if the stock had traded down by $1 to $9 instead, then just as the percentage gain on the margin traders account was double, the margin traders loss in this example would be double as well.

Because trading on margin increases the risk on a traders account, there are additional rules and regulations we must be aware of surrounding the use of margin, which we will learn about in our next lesson so I hope to see you then. As always if there are any questions or comments please leave them in the comments section below, and good luck with your trading!

Other Links to Help You Learn About Trading on Margin

Margin Trading : Introduction
Margin (finance) - Wikipedia, the free encyclopedia
U.S. Securities and Exchange Commission - "Margin: Borrowing Money To Pay For Stocks"
Trading Margin - The ABC’s Of Margin Trading

10-21-2008, 12:33 PM	#1 (permalink)
David Waring InformedTrades Founder Community Host Badges About Assets Total Awards: 4 Join Date: Nov 2007 Location: Miami, FL Posts: 5,632 InformedPoints: 0.13	How to Trade Stocks on Margin Part 1 How to Trade Stocks on Margin (Part 1) Previous Lesson Next Lesson - Full Course In our last lesson we finished up our module on how to place stock trades, with a look at how traders protect their profits, through the use of something known as a trailing stop. In this lesson we are going to start a new module with a look at trading stocks on margin. Like the concept of short selling, trading on margin is one of the more confusing concepts that traders encounter, regarding the logistics of trading. Trading on margin, very simply involves the use of money borrowed from a trader's broker, which increases buying power and allows traders to amplify both their profits and losses. To help understand the concept of margin, lets start with an example that many people are more familiar with, getting a mortgage to buy an apartment. For this example lets say there are two people who are buying apartments in the same building, each of which costs $100,000. The first buyer in our example pays the full $100,000 purchase price in cash. The second person does not have the full $100,000, so instead he puts down $20,000 of the purchase price, and obtains the rest of the $100,000 cost of the apartment by obtaining a loan for $80,000 from his local bank. Next lets say that over the course of the next year, the price of both apartment goes up by $5000 to $105,000. While both of the people in our example have a $5,000 gain on their apartment, the percentage return on their money is quite different. For the buyer who put up the full $100,000 purchase price, the $5,000 increase in the value of the property represents a 5% gain on his money (5,000/100,000 = 5%). For the buyer who put up only $20,000 however that same $5,000 increase in the value of the property represents a 25% gain on his money (5,000/20,000 = 25%). Now that we understand this, we can see that the reason why some traders choose to trade on margin is to try and amplify the gains on their capital when trading, in exactly the same manner as I have outlined above with the two apartments. While the ability to amplify one's gains through the use of borrowed money is certainly an advantage, it is also important to understand that trading on margin is a sword that cuts both ways. In other words just as the use of margin amplifies the gain, as you can see using the above example if the price goes down by $5,000 instead, losses are amplified as well. So to take a stock trading example, lets say that we have two traders each who buy 100 shares of a stock which is trading at $10 per share. The first trader trades on an account without the right to use margin, which is known as a cash account, so he needs the entire $10,000 purchase price of the stock available in his account in order to buy this stock. The second trader, trades on an account with the right to use margin, which is known as a margin account. This trader is able to borrow up to 50% of the purchase price of the stock, so he only needs to have $5,000 in his account in order to purchase the same $10,000 worth of stock. If the price of the stock trades up from $10 to $11, then both traders have a gain of $1 per share on their 100 shares for a total gain of $100. While this however represents a 1% gain on the first traders cash account (100/10,000 = 1%) it represents double the return, or a 2% gain on the second traders margin account (100/5000 = 2%). To simplify the example here I have not included commission costs or the cost of the interest traders pay on margin positions, which we will cover in coming lessons. Also, keep in mind here that if the stock had traded down by $1 to $9 instead, then just as the percentage gain on the margin traders account was double, the margin traders loss in this example would be double as well. Because trading on margin increases the risk on a traders account, there are additional rules and regulations we must be aware of surrounding the use of margin, which we will learn about in our next lesson so I hope to see you then. As always if there are any questions or comments please leave them in the comments section below, and good luck with your trading! Other Links to Help You Learn About Trading on Margin Margin Trading : Introduction Margin (finance) - Wikipedia, the free encyclopedia U.S. Securities and Exchange Commission - "Margin: Borrowing Money To Pay For Stocks" Trading Margin - The ABC’s Of Margin Trading __________________ InformedTrades University \| IT Shopping Guide \| Site Map Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades. Last edited by Simit Patel; 02-18-2010 at 03:12 PM.

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