The Pros and Cons of Trading with Margin

Knowing how to use leverage (a.k.a. margin) effectively can be a secret weapon in your trading tool belt.

It sometimes gets a bad rap, but there’s nothing inherently wrong with using leverage.

In fact, if you’re trading a small account, it might be difficult to grow that bad boy without the help of leverage.

But, like many trading tools, leverage has its pros and cons…

Leverage can boost your profits, but if you’re not careful, it can also increase your losses. 

Certain sectors are perfect for using leverage, while with others, you should avoid it like the plague 

Today, I’ll show you the good and bad sides of leverage using real-life examples. 

That way, you’ll understand how leverage works, why it matters, and how it can potentially increase your trading profits…

What is Margin?

When you hear about leverage or margin, understand that it’s a standard feature in the brokerage industry. 

Almost every broker offers a margin account. 

This type of account allows you to trade with borrowed money, amplifying your buying power. 

The leverage ratio can vary; some brokers offer 2:1, others 4:1, and in the Forex world, it’s not uncommon to see insanely high 100:1 leverage.

For example, with a 4:1 margin account, if you deposit $1,000, your buying power increases to $4,000. 

You still only have $1,000 in your account, but you can purchase up to $4,000 worth of stocks. 

This leverage is designed to amplify your gains. If a stock’s price increases, the potential returns on your investment are significantly higher. 

This is particularly beneficial for traders looking to maximize their returns on a small account in a relatively short period.

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Why is Margin Important?

Margin is most effectively used when trading higher-priced stocks that move slowly. 

It allows you to make potentially meaningful gains on stocks that might not fluctuate much in price. 

For instance, if you wanted to trade a stock like Netflix Inc. (NASDAQ: NFLX) — which is around $640 per share and doesn’t move dramatically — using leverage would be a reasonable decision. 

The ability to amplify gains on such high-priced stocks is one of the primary reasons margin accounts are attractive to experienced traders.

However, it’s crucial to remember that while leverage can amplify gains, it also magnifies losses. 

This dual nature of leverage makes it a powerful (but potentially dangerous) tool. That’s why you’ve gotta understand how to use it appropriately…

The Risks of Margin

If a stock’s price drops while you’re using margin, your losses are multiplied by the leverage ratio. 

This is particularly dangerous with sketchy penny stocks, where price swings can be drastic, unexpected, and sudden.

This amplification of losses is why I strongly advise against using margin for trading low-priced, volatile stocks. 

If you find yourself tempted to use margin with penny stocks, you’re being greedy. These shady stocks already move so much without leverage, there’s no good reason to amplify your returns in either direction. 

Don’t believe me? Just look at recent multi-day runner Faraday Future Intelligence Electric Inc. (NASDAQ: FFIE)…

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The stock ended up surging 6,856% in four days.* You don’t need to use margin when you can swing nearly 7,000% in less than a week.

 

After all, look what happened to this chart a few days later…

This is why I’m constantly warning traders about the dangers of penny stock margin in Pre-Market Prep.

The potential for massive losses is too great. Using leverage in this context can lead to catastrophe, wiping out your entire account…

What Traders Overlook About Margin

Many traders focus only on the potential for increased gains and overlook that margin amplifies losses just as much.

If the share price drops below your entry level, the losses can exceed your initial investment, resulting in owing more money to the broker than was originally deposited. 

This scenario can lead to significant disaster, including margin calls, locked accounts, and even collection efforts from your broker. 

These are not things you want to happen to you. 

However, these problems are pretty easy to avoid. You simply need to remember both the benefits and the risks before engaging in margin trading. 

Be selective about when and where you employ this strategy.

Leverage should only be considered by consistently profitable traders who have honed their skills and developed solid risk management strategies. 

Trading with a cash account until you reach this level of proficiency is the safest approach. 

If you’re looking to improve your trading strategies and risk management, I recommend checking out the Daily Income Trader system. 

We emphasize risk management daily because your primary job as a trader is to manage risk effectively. 

This system provides valuable insights into managing trades, understanding market conditions, and applying strategies that help preserve your money. 

Have a great day everyone. See you back here tomorrow. 

 

Tim Bohen

Lead Trainer, StocksToTrade

 

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