Margin can be a powerful tool to leverage your investment returns or to finance purchases apart from your portfolio. Traders should learn all they can about the benefits and risks of employing margin before deciding whether to incorporate it into their trading strategy.
What is Margin?
Margin is an extension of credit from a brokerage company using your own eligible securities as collateral. Funds borrowed on margin may be used for any purpose, however, traders most typically use margin as a means to purchase additional securities. Interest is charged on the borrowed funds for the period of time that the loan is outstanding. There is no set repayment schedule for a margin account loan; however, a certain minimum level of assets must remain in the margin account in order to maintain sufficient collateral.
The use of margin is regulated by financial industry regulatory organizations and certain securities exchanges, and is subject to the policies of the broker-dealer holding the account.
Margin Benefits and Features
A margin loan can provide a variety of key advantages:
- Leveraging of investments. Buying on margin affords you the potential to achieve greater investment returns by allowing you to own more securities than would be possible on a cash-only basis. A margin account also enables you to sell short (borrow shares from your brokerage firm to sell immediately and repurchase them, hopefully, at a lower price in the future) and potentially profit from downward price movements.
- Trading flexibility. Take advantage of timely market opportunities or make investment changes when you want, as long as you maintain the minimum equity required.
- Stay invested. Keep your investment strategy on track and defer any capital gains taxes that might result from selling securities to meet your financing needs.
- Portfolio diversification. If you hold a concentrated stock position, you can use margin to purchase other securities in order to diversify your portfolio.
- Convenience. Once the margin feature is approved and activated on your account, you can borrow against the account equity at any time without any additional paperwork or waiting for loan approvals (subject to the terms, limitations, and requirements of the firm's margin agreement). Please note that some types of brokerage accounts are not eligible for margin (e.g., and without exclusion, IRAs, 401(k)s, 403(b)s, UGMAs and UTMAs).
- Repayment simplicity. There is no set repayment schedule as long as you maintain the required level of equity in your account.
- Competitive interest rates. Margin borrowing is generally more cost-effective than consumer lending options like credit cards.
- Ready line of credit. A margin loan is a ready source of credit that may be used for purchasing securities or other needs.
- Tax deductibility. Interest on margin loans may be tax deductible against your net investment income. However, you should consult your tax advisor regarding your own situation.
Example: A Gain Achieved Without the Use of Margin
The use of margin can magnify your profits as well as your losses. Let's look at two examples that illustrate the difference between using margin and not using margin to purchase securities.
The following example demonstrates the upside potential for a trade that does not involve the use of margin. For the sake of simplicity, we'll ignore trading fees and taxes. Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year later the price of the stock stands at $70. Your shares are now worth $7,000. You sell your shares and in the process you realize a profit of $2,000.
Example: A Gain Achieved With the Use of Margin
What happens when you add margin into the mix? This time you use your $5,000 in cash and you also borrow another $5,000 on margin from your brokerage firm. This gives you buying power of $10,000 which allows you to buy 200 shares of that $50 stock instead of only 100 shares.
If, a year later, the stock reaches $70 and your 200 shares are worth $14,000. You sell the shares and pay back the $5,000 of margin money you borrowed plus $400 in interest (this amount will vary depending on the amount of time the money is borrowed and the rate of interest charged by the brokerage firm) which leaves you with $8,600. If you subtract the $5,000 of cash you invested initially, this leaves of profit of $3,600.
In the first example-where no margin was used-you earned a profit of $2,000 on an investment of $5,000 for a gain of 40%. In the second example-where margin was used-you earned a profit of $3,600 on that same $5,000 for a gain of 72%. These two examples illustrate the possibility of achieving a higher rate of return via the use of margin.
Margin exposure also presents additional risks. When considering a margin loan, you should determine how the use of margin fits your own risk tolerance and investment goals. It is important that you fully understand the risks involved using margin:
- Leverage Risk. Leveraging means using margin to potentially capture more returns than when investing on a cash-only basis. It is important to recognize that unfavorable market moves can negatively impact the value of your investments more rapidly. Leveraging exposes you to greater downside risk versus paying for securities in full because if the securities acting as collateral for your margin loan lose value, you must still either repay your brokerage the amount of money you borrowed on margin or be required to deposit more money into your account.
- Interest Rate Risk. Like any other loan, you must repay your margin loan along with interest, regardless of the underlying value of the securities purchased. Keep in mind that it is possible that margin interest rates may fluctuate during the time you have an outstanding loan. You may not receive any notice of margin interest rate change from your brokerage firm.
- Maintenance Call Risk. If the equity in your account falls below the brokerage firm's minimum maintenance requirements due to the value of your shares held as collateral dropping in value, your brokerage firm will issue a "maintenance call." A maintenance call requires you to deposit additional cash or acceptable collateral into your account promptly. Your brokerage firm may increase its margin maintenance requirements at any time without prior notice.
- Forced Liquidation Risk. If you fail to meet a margin call, your brokerage firm may sell some or all of the securities in your account without contacting you. You are not entitled to an extension of time on a margin call.
Example: A Loss Achieved Without the Use of Margin
Margin can increase profits when stocks are rising in price. However, the magnifying effect can work against you as well.
Jumping back into our example, what if you use your $5,000 cash to buy 100 shares of a $50 stock, and it goes down to $30 over the course of the next year? Your shares are now worth $3,000, and you've lost $2,000.
Example: A Loss Occurring With the Use of Margin
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 sell your shares for $6,000, you still have to pay back the $5,000 loan along with $400* interest, which leaves you with only $600 of your original $5,000-for a total loss of $4,400. As you can see, when taken to the limit, trading on margin makes it possible to lose your initial investment and still owe the money you borrowed plus interest. This is why it is important to be aware of the risks before starting to trade using margin.
Tips For Managing Margin Risk
- Don't be fully leveraged. Borrow less than the maximum amount allowable in your account to allow room for fluctuation in the event of an unfavorable market movement. Set a personal minimum account equity level for yourself that is higher than your brokerage firm's house requirements and monitor your portfolio to check that you are not going below that equity level.
- Borrow against a diversified portfolio. This reduces the risk that a single security's drop in value will trigger a maintenance margin call.
- Closely watch your portfolio. Be aware of what is going on in the market. Recognize that margin usage brings increased risk, and constantly reassess your risk tolerance. Anticipate a potential decline in value, especially during uncertain market conditions.
- Have a plan. When you use margin, have a plan in mind. Develop a risk management strategy for your investments that is consistent with your market outlook, and stick to it. Develop contingency plans for dealing with potential margin calls, and have a repayment plan ready if the market turns, if margin maintenance requirements rise, or if margin interest rates rise.
*The calculations in this example do not take into account all interest charges, commissions or fees.
Margin borrowing may not be right for everyone. It's important that you fully understand your financial situation, the rules of margin borrowing, and conditions that may affect your investments.
Before you begin using margin, you should read Schwab's Margin Borrowing Overview and Disclosure Statement. To learn more or refresh your knowledge about margin lending you can refer to The Schwab Guide to Margin.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.