Content of the material
- What is margin?
- Margin interest
- Where there’s potential reward, there’s potential risk
- A convenient line of credit
- About the Author
- Understand Margin Calls – You Can Lose Your Money Fast and With No Notice
- What’s Considered “Margin?”
- How Does Margin Trading Work?
- Margin Trading Scenario 1
- The Problem With This Scenario
- Margin Trading Scenario 2
- Recognize the Risks
- How many people use margin for trading?
- The risks of margin
- What’s the difference between margin trading and short selling?
- How About an Example of Trading on Margin?
- Dangers of margin trading
- What is a margin call?
- What Does a Margin Call Mean?
- Related Coverage inInvesting:
- Robinhood tells users to raise their cash buffers on several popular stocks hours before the market open
What is margin?
The simple definition of margin is investing with money borrowed from your broker.
There are two primary types of brokerage accounts. In a cash account, you invest your own money. In a margin account, you can borrow from the brokerage based on how much you have invested. When you invest with a margin account, you’re able to purchase stocks according to your “buying power,” which includes both your own cash and a loan against the money you have invested.
As with any loan, when you buy securities on margin you have to pay back the money you borrow plus interest, which varies by brokerage firm and the amount of the loan.
Margin interest rates are typically lower than those on credit cards and unsecured personal loans. There’s no set repayment schedule with a margin loan—monthly interest charges accrue to your account, and you can repay the principal at your convenience. Also, margin interest may be tax deductible if you use the margin to purchase taxable investments and you itemize your deductions (subject to certain limitations; consult a tax professional about your individual situation).
Where there’s potential reward, there’s potential risk
While margin loans can be useful and convenient, they are by no means risk free. Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.
A convenient line of credit
Once your account has been approved for margin borrowing, you can take out a margin loan at any time, without any additional forms or applications. This ready access to cash may prove to be convenient in a number of scenarios, such as when you are unemployed, experience an unexpected medical bill, or need a quick way to access cash for any other reason. If your brokerage account includes checking, you can simply write a check.
About the Author
Vance Cariaga is a London-based writer, editor and journalist who previously held staff positions at Investor’s Business Daily, The Charlotte Business Journal and The Charlotte Observer. His work also appeared in Charlotte Magazine, Street & Smith’s Sports Business Journal and Business North Carolina magazine. He holds a B.A. in English from Appalachian State University and studied journalism at the University of South Carolina. His reporting earned awards from the North Carolina Press Association, the Green Eyeshade Awards and AlterNet. In addition to journalism, he has worked in banking, accounting and restaurant management. A native of North Carolina who also writes fiction, Vance’s short story, “Saint Christopher,” placed second in the 2019 Writer’s Digest Short Short Story Competition. Two of his short stories appear in With One Eye on the Cows, an anthology published by Ad Hoc Fiction in 2019. His debut novel, Voodoo Hideaway, was published in 2021 by Atmosphere Press.
Understand Margin Calls – You Can Lose Your Money Fast and With No Notice
If your account falls below the firm’s maintenance requirement, your firm generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm’s maintenance requirement.
Always remember that your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm’s maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.
What’s Considered “Margin?”
Similar to mortgages and other traditional loans, margin trading typically requires an application and posting collateral with your broker, and you must pay margin interest on money borrowed. Margin interest rates vary among brokerages. In many cases, securities in your account can act as collateral for the margin loan. (A TD Ameritrade account that’s approved for margin trading must have at least $2,000 in cash equity or eligible securities and a minimum of 30% of its total value as equity at all times.)
How Does Margin Trading Work?
Margin trading requires a margin account. This is a separate account from a “cash account,” which is the standard account most investors open when they first start trading.
All securities in your margin account (e.g., stocks, bonds) are held as collateral for a margin loan. If you fail to meet a margin call by depositing additional assets, your broker may sell off some or all of your investments until the required equity ratio is restored.
The maintenance requirement varies from broker to broker. This is the ratio between the equity of your holdings and the amount you owe. In other words, it’s how much you can borrow for every dollar you deposit. The brokerage firm has the right to change this at any time. The interest rate your broker charges on margin loans is subject to change as well.
It is possible to lose more money than you invest when margin trading. You will be legally responsible for paying any outstanding debt.
Margin Trading Scenario 1
Imagine an investor deposits $10,000 into an otherwise empty margin account. The firm has a 50% maintenance requirement and is currently charging 7% interest on loans under $50,000.
The investor decides to purchase stock in a company. In a cash account, they would be limited to the $10,000 they had deposited. However, by employing margin debt, they borrow the maximum amount allowable, $10,000, giving them a total of $20,000 to invest. They use nearly all of those funds to buy 1,332 shares of the company at $15 each.
After buying the stock, the price falls to $10 per share. The portfolio now has a market value of $13,320 ($10 per share x 1,332 shares). Even though the value of the stock fell, the investor is still expected to repay the $10,000 they borrowed through a margin loan.
The Problem With This Scenario
Aside from the outstanding debt, this scenario presents another serious problem. After accounting for the $10,000 debt, only $3,320 of the stock value is the investor's equity. That makes the investor's equity roughly 33% of the margin loan. The broker issues a margin call, forcing the investor to deposit cash or securities worth at least $6,680 to restore their equity to the 50% maintenance requirement. They have 24 hours to meet this margin call. If they fail to meet the maintenance requirement in that time frame, the broker will sell off holdings to pay the outstanding balance on the margin loan.
Had the speculator not bought on margin and instead only bought the 666 shares they could afford with cash, their loss would have been limited to $3,330. Furthermore, they wouldn't have to actualize that loss. If they believed the stock price would bounce back, they could hold their position and wait for the stock price to rise again.
However, since the trader in this scenario used margin trading to buy the stock, they must either cough up an extra $6,680 to restore the maintenance requirement and hope the stock bounces back, or sell the stock at a $6,680 loss (plus the interest expense on the outstanding balance).
Margin Trading Scenario 2
After purchasing 1,332 shares of stock at $15, the price rises to $20. The market value of the portfolio is $26,640. The investor sells the stock, pays back the $10,000 margin loan, and pockets $6,640 in profit (though this doesn't account for interest payments on the margin loan). If the investor hadn't used margin to increase their buying power, this transaction would have only earned a profit of $3,333.
Recognize the Risks
Margin accounts can be very risky and they are not suitable for everyone. Before opening a margin account, you should fully understand that:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses;
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
- Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.
You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines. Know that your firm charges you interest for borrowing money and how that will affect the total return on your investments. Be sure to ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.
How many people use margin for trading?
Many people use margin for trading. According to FINRA, as of May 2021, investors have borrowed $861 billion for margin trading. Investors have $213 billion in their cash accounts and $234 billion in their margin accounts.
The risks of margin
Margin can magnify profits when your stocks are going up. However, the magnifying effect works the other way as well.
Imagine again that you used $5,000 cash to buy 100 shares of a $50 stock, but this time imagine that it sinks to $30 over the ensuing year. Your shares are now worth $3,000. If you sell, you’ve lost $2,000.
A loss without margin
You pay cash for 100 shares of a $50 stock
Stock falls to $30 and you sell 100 shares
But what if you had borrowed an additional $5,000 on margin and purchased 200 shares of that $50 stock for $10,000? A year later when it hit $30, your shares would be worth $6,000. If you sold for $6,000, you’d still have to pay back the $5,000 loan and $400 interest, leaving you with only $600 of your original $5,000—a total loss of $4,400.
A loss with margin
You pay cash for 100 shares of a $50 stock
You buy another 100 shares on margin
Stock falls to $30 and you sell 200 shares
You repay margin loan
You pay margin interest
If the stock had fallen even further, you could theoretically lose all of your initial investment and still have to repay the amount you borrowed, plus interest.
What’s the difference between margin trading and short selling?
There are some similarities between margin trading and short selling since both involve additional risks. However, the mechanics of short selling are much different from margin trading.
Short selling means borrowing shares from your brokerage with the intent of buying them back at a lower price. That strategy works when the share price falls, but it can easily backfire. If the stock goes up, you lose money, and, unlike owning a stock, your losses are theoretically unlimited.
In this sense, short selling is even riskier than margin trading because you can be on the hook for an unlimited amount of money. With margin trading, you’re only at risk of losing what you’ve invested and borrowed. Like margin trading, short selling generally requires traders to put up collateral, and a short seller can also be subject to a margin call forcing them to close out their bet.
What margin trading does have in common with short selling is that it should only be considered by very experienced investors who fully recognize the risks. Even then, those investors who want to use them should carefully limit their total exposure so that, when the market moves against them, it doesn’t jeopardize the rest of their financial position.
While margin trading can be advantageous at times, overall the risks of borrowing from your brokerage outweigh the benefits.
How About an Example of Trading on Margin?
Let’s say you want to buy 1,000 shares of a stock that’s currently trading at $50 per share. If you bought it with only the cash in your account, you’d need $50,000. But if you bought the shares through a margin account, you’d only need to have $25,000 in your account to purchase them—the other $25,000 would be funded by margin.
If the stock rises from $50 to $55 per share (for a gain of $5 per share, or $5,000), you’d have a 20% profit, because the gain is based on the $25 per share paid with cash and excludes the $25 per share paid with funds borrowed from the broker.
But margin cuts both ways. If the stock dropped to $45 per share, you’d have a loss of 20%—double what the loss would be if you paid for the stock entirely in cash.
Dangers of margin trading
Using leverage to increase investment size, as margin trading does, is a two-edged sword. On one hand, it can significantly increase your rate of return. But losses can also multiply fast. For example, a 50% decrease in a stock’s value could wipe out your account’s cash balance entirely — because you’re still on the hook to repay the amount you originally borrowed.
There’s another risk: A decline in your investments can lead to an account falling below the broker’s maintenance margin (the minimum balance, in either cash or securities, that you’re required to keep in the account). When this happens, the broker will issue a margin call.
What is a margin call?
A margin call is your broker basically demanding or “calling in” part of your loan. A margin call requires more funds to be added to your account to bring its balance back above the minimum requirements.
If you can’t promptly meet the margin call, your broker has the right to sell some of your securities to bring your account back up to the margin minimum. What’s more, your broker does not need your consent to sell your securities. In fact, they may not be required even to make a margin call beforehand.
The potential for a margin call and the involuntary sale of assets makes trading on margin riskier than other forms of financing.
With a mortgage, for instance, your lender can’t foreclose on your home just because its appraised value has gone down. As long as you continue to make your mortgage payments, you get to keep your home and can wait to sell until the real estate market rebounds.
But with margin trading, you can’t always just wait out dips in the stock market. If the stock price falls and your equity dips below the minimum margin trading requirement, you’ll need to add more capital or risk having some of your securities sold at a serious loss.
Your equity percentage, or ownership stake in the company, is calculated by dividing the current value of your securities by your debt. Let’s say you bought $12,000 of securities with $6,000 of cash and $6,000 of margin. In this case, your starting equity percentage would be 50% ($6,000/$12,000 = 0.50).
If the value of the securities dropped to $8,000, your equity would fall to $2,000 ($8,000- $6,000 = $2,000). This would bring your equity percentage down to 25% ($2,000/$8,000 = 0.25). If your broker’s maintenance requirement was 30% equity, this drop would trigger a margin call.
What Does a Margin Call Mean?
If the equity in your account falls below the maintenance margin requirement, you’ll face a margin call. A margin call requires one of two actions to immediately increase the equity in your account. The first is to deposit enough money to get your account above the maintenance margin level. The second is to sell enough securities to satisfy the margin call. If you don’t resolve the issue immediately, your brokerage firm might liquidate your securities without your permission.
Related Coverage inInvesting:
Robinhood tells users to raise their cash buffers on several popular stocks hours before the market open
Clint Proctor Clint Proctor is a freelance writer and founder of WalletWiseGuy.com, where he writes about how students and millennials can win with money. When he’s away from his keyboard, he enjoys drinking coffee, traveling, obsessing over the Green Bay Packers, and spending time with his wife and two boys. Read more Read less