One of the ways you can potentially increase your profits is to trade on margin. When you put up collateral as leverage in order to place a bigger order, you have the chance to increase your profits, since a bigger order means the potential for bigger gains.
This is especially true when trading options or currencies on margin.
With options and currencies, smaller movements matter more, and the way these investments are traded makes them especially compatible with margin trading.
However, you still have to be careful when you trade on margin. The leverage can potentially increase your profits, but there’s also the chance you’ll end up losing more than you bargained for.
Consider a gambling trip with your friend — you don’t have enough to keep going, so you ask your friend to lend you $100. If win big with that $100, paying your friend is no problem. But if you lose, you still have to come up with that $100 to repay your friend — and you’ve already lost all the money you had to begin with.
When you trade on margin, you have to consider the possibility that you’ll lose more than you had originally, and you have to take steps to make sure you can truly afford to trade on margin.
Margin Rates and Your Investment
When you trade on margin, you have to be aware of the possible consequences. First of all, realize that you are borrowing and will have to pay interest on the amount you receive.
Many online discount brokers offer margin accounts, and they post their rates. These rates represent an amount of interest you have to pay on what you’ve borrowed.
If your leveraged trade turns out well — and you profit — it’s usually not a problem to repay the amount you borrowed (plus the interest).
On the other hand, though, if you lose out, not only do you have capital losses, you also have to repay the amount you used to trade (plus the interest). This means that some of your other assets could be at risk.
Trading on Margin is Risky
You don’t have to just worry about whether or not you can afford the magnified losses when you trade on margin; you also have to consider how rising margin rates can affect your overall returns.
Brokers can adjust their margin rates as they see fit. As a result, as margin rates rise, your investment returns are impacted.
First of all, even if you profit, your real returns are eroded, since you have to pay a higher interest on the amount you borrowed. If you lose, the impact is even greater, since you have the negative impact associated with higher margin rates coming home to roost.
With rising margin rates, you might also be limited by how much you can borrow to make your trade. You might not be able to borrow as much as you’re used to in order to log your potential profits.
When that happens, you can lose out on what might have been even better overall returns. Pay attention to margin rates, and be careful when you invest using leverage.