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Active Trading vs. Buy and Hold Part 3

The short term approach to trading offers opportunities to realize capital gains not only by trend analysis but also through shortterm investing devices that can possibly accelerate potential gains.  One of these techniques is leveraging which is often implemented by margin. 

This reminds me of a conversation I once had at the dinner table.  I was talking with some friends that came over for dinner and the word margin came up.  My middle son asked me what margin was and before I could answer my youngest son proceeded to tell him that margin is what you spread on your toast when you don't want butter. I know that's off topic but to this day every time I hear the word margin it reminds me of what he said.  The things kids will come out with sometimes! You had to be there. 

Margin is borrowed money. When you are on margin you are borrowing money from your broker to buy stocks.  If you had an account with $20000 in it and you borrowed an additional $10000 from your broker (subject to interest) this would give you a total of $30000 of buying power even though you only have $20000 of your own money.  Margin requirements have changed over the years and they have become more stringent to help protect market participants from losing substantial amounts of money.  These laws were changed after the 2000 meltdown of the dot bomb era although the changes came too late again as usual. 

Many day traders use margin to maximize gains and close out the margin positions at the end of the day.  For example if you made a trade today that yielded you a 5% return by using the entire $30000 balance in the one trade you would make $1500 for the day. Many stocks go up 5% in a single day so it is possible scenario. Your return on the trade would be $1000 if you had not used the margin and just used your own $20000 on the trade.  Still not a bad day's work but the point is that your gains can be 50% more with the use of margin. The drawback is that you have to be right.  If the trade goes bad your losses increase. In our example if the stock went down 5% in a day you lose 7.5%. 

Some of the dangers of using margin for long term investments include: 
1. Interest charges that add up on the borrowed money offsetting some of the gains in the stock price. 
2. If a stock experiences a 20% decline you will suffer a greater loss. Hopefully a stop loss order is in place to prevent a heavy loss like this but long term investors are unlikely to use tight stop orders because they do not worry about a short term decline in the stock. However when you are on margin it is imperative that you worry about fluctuation in stock price. Should the investment experience a 50% decline you would lose 75% of your original investment. 

Margin is dangerous because it is possible to lose more than the initial investment.  As such margin is a trading tool that should be used only by experienced traders who are skilled in the art of timing entry and exits on short term trades.  Also since margin is borrowed money so the less time you take to pay it back the less interest you will owe.  If you take a long time to try to reap profits from a trade the cost of margin can eat into your overall return. 

We would not suggest using margin since stocks are falling off a cliff in this recent selloff but it is another day trading tool should you decide you want to use it to increase your day trading buying power.  The way the market is selling off now this is not the time to use margin for anything else but day trading.

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