It's important to weigh the risks and the advantages of trading in a margin account, relative to a cash account. So let's take a look at some key considerations:
In a margin account, your positions will usually be more sensitive to day-to-day market fluctuations, and if there's a really sharp decline, you could end up losing more than the total value of your account. Additionally, you're always required to maintain a minimum level of equity in a margin account; usually about 30% to 35% for most stocks.
If your securities should start to decline in value, and fall below this level, you'll be required to deposit additional money into your account. If you're either unable or unwilling to do this, your broker can close out the securities in your account to increase your equity. Unfortunately, when this happens, it could be at the worst possible time and at the worst possible price.
And the risks don't end there. If your positions lose value too quickly and your margin loan balance exceeds the proceeds from the securities your broker closed out, you could end up with no securities at all, but still owing money.
On the up side, when you trade in a margin account, you can typically borrow up to 50% of the cost of any new securities. That means you can buy up to twice as many shares as in a cash account, and this might let you take advantage of short-term market opportunities without selling any of your existing positions.
It can also make it easier to diversify your portfolio if you are overly concentrated but you don't want to sell any of your holdings.
When you trade in a cash account, your potential loss is limited to the amount you've invested, and since you own your securities outright, you get to decide when, or if, to sell them. And you won't be forced to sell them during unfavorable market conditions due to a margin call.
But if you only trade in a cash account, and the stock you buy goes up, your profits will usually be less than if you traded in a margin account and bought more shares.
Always remember that this is a loan and you will incur interest charges. Whether your trades end up being profitable or not, eventually you'll have to pay back the loan, plus margin interest charges.
There's no set repayment schedule on a margin loan. Instead, the loan is paid in full when the securities are sold. However, when you use margin to buy stock, the margin interest is often tax-deductible against your capital gains and investment income.
Trading on margin can increase your gains if you make good investing decisions, but it can also increase your losses when you don't.
If you feel like margin trading might be right for you, it's easy to get started. When you open an investing account with your broker, unless it's an IRA or some other type of retirement account, you'll usually be offered the opportunity to apply for a margin account.
While it's typically never a good idea to use all of your available margin, leverage can give you the flexibility to take advantage of investing opportunities that might not be possible in a cash account.
If you'd like to learn more about margin trading, check out the next video.