Chapter 3: When to Use Margin Trading
The margin is essentially a loan from your broker, and like any other loan, it has to be paid back. Until you repay it, the broker charges you interest. The longer you hold the loan the greater the interest amount you would have to pay. This often makes long term investments with margin buying unviable because the costs of borrowing may well set off any gains that you make from the investment.
Short term investments in stocks which show a lot of potential for growth in the near future are good margin buying opportunities. When you stand to gain a lot in a short period, you can use the gains to pay off the interest that would accrue during the short span of the loan.
However, you should always assess the risk of a loss in your trade. Make sure that you will be able to fund the maintenance margin if the stock price starts falling. If you can’t afford a potential loss, margin trading is not the right option for you.
Margin buying has some limitations, which affect how you can invest and what you stand to gain.
The Federal Reserve imposes restrictions on the securities which can be bought on margin. In general, high risk investments are not marginable. Brokerages can further choose to restrict securities that their customers can buy on margin in addition to Fed limitations. Check with your broker before you begin margin buying to find out if the securities you are interested in can be bought on margin.
When your margin account balance falls below the minimum level that needs to be maintained, the broker can limit your transactions until you top up your account or sell the securities.
In spite of these limitations margin buying is still a very attractive option and experienced investors often use margins to increase their profits.
Next Chapter: Risks Associated with Margin Trading