Margin trading is when traders utilize borrowed funds to buy additional stock. To engage in margin trading, day traders need to open an additional margin account. This account allows traders to buy more stock than their cash-on-hand would otherwise allow. Day trading on margin can be intimidating for traders learning day trading basics because it amplifies profits and losses.
With that in mind, let’s take a look at some of the pros and cons that traders weigh when deciding whether to start day trading on margin:
Pros
- Leverage: Day trading on margin is attractive because of the leverage gained. In some cases, day traders only need to put down as little as 25% when trading on margin. That means day traders can move $100 worth of stock for only $25. This is one of the reasons why brokers require day traders to exit half of their positions before the market closes each day.
- Increased Profit Opportunity: Moving four times the amount of stock increases(more information about how to buy shares) a day trader’s ability to lock in profits when executing a successful trade. A typical cash transaction would offer a 50% return if the stock increased by 50%. But with 4x leverage, if a stock were to increase by 50% the day trader would receive a staggering 300% return.
Cons
- Increased Loss Opportunity: Of course, the inverse of the profit opportunity is true. Day trading on margin is the only type of trading where a trader could potentially lose more than their initial investment. On top of a potentially huge loss, a trader is also responsible for covering the interest and commissions.
- Altering Strategy: When a trader is day trading on margin and an asset starts to tank, the trader may have to exit a position quicker than they would like to in order to prevent severe losses.
- Margin Calls: Traders are responsible for keeping a minimum balance in their margin account. When the value of their stocks dip below the minimum requirement, the broker may force the trader to add more to their margin account or exit their positions. Failure to respond to the margin call can cause brokers to sell a trader’s securities to meet the minimum margin requirement.
Day trading on margin is a risky endeavor that requires a firm handle on day trading basics and a real grasp of the psychology of trading and assessing risk. To many of you, margin probably sounds exciting AND nerve-wracking at the same time!
