Wednesday, 7 December 2016

The Advantages and Disadvantages of Margin Trading

The Advantages of Margin Trading

1.   A magnified return is the major advantage of margin trading.

The size of the magnified return depends on both the price behaviour of the security and the amount of margin used.

2.   Another more modest benefit of margin trading is that it allows for greater diversification of security holdings because investors can spread their limited capital over a larger number of investments.

The Disadvantages of Margin Trading

1.   The major disadvantages of margin trading, of course, is the potential for magnified losses if the price of the security falls.

2.   Another disadvantage is the cost of the margin loans themselves.  

A margin loan is the official vehicle through which the borrowed funds are made available in a margin transaction.

All margin loans are made at a stated interest rate, which depends on prevailing market rates and the amount of money being borrowed.

This rate is usually 1% to 3% above the prime rate - the interest rate charged to creditworthy business borrowers.

For large accounts, it may be at the prime rate.

The loan cost, which investors pay, will increase daily, reducing the level of profits (or increasing losses) accordingly.

Take home message:

Margin trading can only magnify returns, not produce them.

One of the biggest risks is that the security may not perform as expected.

If the security's return is negative, margin trading magnifies the loss.

Because the security being margined is always the ultimate source of return, choosing the right securities is critical to this trading strategy.

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