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Margin trading is borrowing funds from a brokerage house to purchase stock in an open exchange. Trading on margin allows an investor to avoid using his own funds — which may have strict limits if the investor has low capital — when making trades in the stock market. Not all investors qualify for margin trading. Brokers typically have strict requirements to ensure they do not extend capital to individuals who are incapable of generating returns that will repay the loaned funds.
Many investors use margin trading when selling stocks short. Investors short stocks by selling shares they do not own. This is common when an investor believes a stock is going down in price. As the company’s stock price decreases, investors selling stocks short make money. In order to do this properly, investors often need margin in order to “sell” stocks in their trading account. The brokerage house will loan the investors money to sell the stock, expecting to recover the funds after the investors “buy” stock at a gain to cover their position. Margin trading is extremely risky because the shorted position can quickly be wiped out if the stock experiences huge gains in one day.
In margin accounts, brokerages may require investors to deposit a certain amounts of funds into their accounts as a safety deposit. This ensures the investors remains financially vested in the trading process. For example, margin trading accounts may require a $5,000 US Dollar (USD) deposit by the investor. When buying stocks or selling them short, the investor can borrow a certain percentage, such as 50 percent, of the total stock purchase that is financed through the broker’s funds. For example, a total purchase price for a group of shares may be $2,500 USD; the investor will put $1,250 USD of the total $5,000 USD in the investment and borrow the remaining funds from the broker.
Trading stocks on margin is not free. Most brokerage firms charge fees or interest on the borrowed funds. Making large trades using margin accounts will result in lower returns, as the brokerage firms will deduct the fees and interest from the money received by the investors. These funds will either reduce future investment gains or increase the losses on a stock trade. Margin trading may also have specific limits imposed by a government, resulting in further limits imposed by brokerage houses. For example, penny stocks or initial public offerings are typically not stocks an investor can sell short per government regulations.