Margin Trading: What It Is, How It Works & Risks
Sometimes, investors may find that there are more investment opportunities out there than they have funds available for. In other cases, investors may have unusually high confidence that they’ve found a sure winner and want to increase the potential gains from trading on that conviction. In both cases, trading on margin may present an opportunity.
What Is Margin Trading?
Margin trading (or “buying/trading on margin”) is the use of funds borrowed from the brokerage to buy more shares than an investor otherwise could. Brokerages charge interest for the use of these funds, which must be paid back. Using borrowed funds to invest can increase an investor’s potential returns, while also increasing the risk of larger losses. Trading on margin also comes with the downside of having less control over your accounts.
Margin & Margin Loan Basics
Margin is a form of collateralized debt used to magnify an investor’s buying power. The margin loan is secured by the value of the cash and securities in the margin account, but the brokerage has the right to claim other assets (cash or stocks held in other accounts, personal assets, et al) to repay the loan as needed. While margin loans are typically used to purchase securities, they can also be used as a line of credit, with the investor taking out funds for purposes unrelated to investing. An investor could withdraw the funds from a margin loan to repay a credit card balance, or fix their car, for instance.
Investors may be familiar with other collateralized loans like a mortgage or auto loan. Margin loans are different in many respects. Margin loans are indefinite in term, the rates can be changed by the lender with minimal notice, and the lender (the brokerage) can also demand immediate repayment. With most collateralized loans, the underlying value of the asset is used to establish the initial terms of the loan, but is then no longer relevant—changes in the value of a house do not impact the terms of the mortgage loan, and a bank cannot demand immediate repayment if the value of the house declines. But margin loans are different.
Key Takeaway: Margin loans do not work like most other forms of debt. The amount of the loan, the interest rate, and the repayment schedule are not fixed and can be changed by the lender (the brokerage) with no notice.
How Margin Trading Works
To buy or trade stocks on margin, an investor must open a margin account.
Step 1: Open a Margin Account
This process is similar to opening a cash account, and many brokerages will offer a margin account as the default account type. There is generally no cost or penalty to using a margin account like a cash account (and no requirement to borrow funds).
Step 2: Review & Sign Margin Agreement
As part of opening a margin account, the brokerage will provide a margin agreement. This may be incorporated into the general account agreement or it may be separate.
The margin agreement will include:
- A notification that the investor must abide by the margin requirements established by the Federal Reserve Board, regulatory organizations like FINRA, security exchanges, and the brokerage.
- How margin interest is calculated
- What securities are eligible
- How the investor is responsible for repaying loans.
- How the brokerage will inform investors of margin calls, etc.
It will also include notifications that margin requirements can be changed with no prior notice and that the brokerage is not required to provide time to fulfill margin calls.
Step 3: Brokerage Agrees to 'Know Your Customer' Standards
As part of the account opening process, the brokerage must comply with a set of standards informally known as Know Your Customer. This includes:
- Verifying the identity of customers
- Establishing a risk profile for the customer, including information about their investing experience and intentions for the account
- Basic financial information like employment status, income, net worth, and banking information
While a margin account application will typically include a credit check, it is rare for a poor credit rating to disqualify an investor for a margin account. Brokerages have their own standards and requirements, though, and a poor credit rating may lead to more strict terms (higher interest rates, higher maintenance minimums, and so on).
Step 4: Account Owner Deposit's Funds
Like with all brokerage accounts after they've been opened, the account owner must deposit funds into the account for it to become active. An investor must maintain at least $2,000 in their account to make use of margin. Brokerages are allowed to set higher minimum standards.
Step 5: Buy Stocks On Margin
After completing the application process, opening the margin account, and depositing funds, an investor can now buy stocks on margin. The process will vary from brokerage to brokerage, but when an investor decides to buy a stock and goes to input the trade, the investor will typically be asked if they wish to input the trade as a cash transaction or a margin transaction. In a cash transaction, the investor must have 100% of the required funds (the value of the shares plus any commissions and fees).
If the investor chooses the margin option, the investor will have to meet the minimum initial margin requirement, which is the higher of 50% (Regulation T) or the brokerage’s minimum initial margin amount. This means when an investor buys a stock on margin, they are allowed to borrow up to half of the value of the transaction. Brokerages can impose stricter requirements.
Important: The amount of leverage an investor can use to start a position (also called the initial margin) is established by regulatory bodies and the brokerage. The Fed’s Regulation T requires a maximum of 50% margin on initial positions.
Step 6: Investor Meets Minimum Maintenance Requirement
Once the trade is complete, the investor will have to meet the ongoing minimum maintenance requirement; FINRA currently has a minimum maintenance requirement of 25%, though most brokerages have higher requirements. Brokerages can also have different minimums for specific securities (higher minimums for more volatile/risky stocks) and specific customers.
Interest will be charged on any outstanding margin loan balance, with charges typically posted on a monthly basis. Interest is typically added to the margin loan balance.
Unlike typical collateralized loans, margin loans are always tied to the fluctuating value of the securities that secure the loan. If a homeowner buys a house and the value of the house declines, it has no bearing on the mortgage loan. If the value of the securities bought on margin changes, it can have a significant impact on the margin loan and the account.
Investors must always maintain a minimum level of equity (cash and eligible securities like stocks and mutual funds, minus borrowed funds) relative to the account value at all times. This ratio is called the maintenance margin, and there are overlapping regulations that establish the minimum maintenance margin. FINRA requires a minimum maintenance margin ratio of 25%, and most brokerages require minimums of 30% to 40%. In all cases, the effective minimum maintenance margin is the highest of these requirements.
If the equity in a margin account falls below the minimum maintenance margin, it will trigger a margin call.
A margin call is a demand from the brokerage to the investor to bring the margin account back above the minimum maintenance level. This can be achieved by depositing cash, transferring more eligible securities into the account, and/or selling some of the margined securities to reduce the margin loan amount.
Brokerages typically give investors three to five days to fulfill a margin call, but this is a courtesy and at their sole discretion; brokerages can demand immediate payment and are not required to issue a margin call.
If an investor cannot, or does not, meet a margin call, the brokerage will take action. These actions can include selling the stocks bought on margin, seizing any cash in the account, and selling other stocks in the account (or other accounts held by the investor at that brokerage) to make up the shortage. These sales are called “forced sales” or “liquidation” and the brokerage has sole discretion as to what securities are sold.
Tip: Margin calls are designed to protect the brokerage’s interests. They are not meant to function like price alerts or stop-loss orders, and a margin call can lead to forced sales before an investor has time to respond.
Interest Costs of Margin Trading
Buying or trading stocks on margin does carry higher costs than regular cash trading, namely the interest that the brokerage will charge on the margin loans.
Buying stocks on margin also typically requires more attention than a cash account, specifically making sure that the account remains above minimum maintenance requirements, which could be seen as a “non-cash” cost.
Example of Buying Stocks on Margin
To understand how buying stocks on margin can work, consider the following example. Please note that that example excludes commissions and margin interest, but both are very real costs that will impact an investor’s returns.
An investor opens a margin account with $5,000 and wants to use margin to purchase 100 shares of XYZ Corp at $100, a transaction that will cost $10,000. Regulation T requires a maximum 50% margin to begin a position, so the investor must contribute a minimum of $5,000 from their own funds, with the remaining $5,000 of funds borrowed from the brokerage (the margin loan).
50% x 100 x $100 = $5,000
In other words, the investor has purchased $10,000 of XYZ Corp (100 shares at $100) by using $5,000 of their own money and $5,000 of money borrowed from the brokerage (the margin loan).
Scenario 1: Share Price Increases
Let's say that, hypothetically, the decision to buy XYZ Corp turned out to be a good one, and the shares move up to $120, at which point the investor decides to sell. The sale generates $12,000 (100 x $120), and the investor pays back the margin loan of $5,000, leaving $7,000,
$12,000 - $5,000 = $7,000
Excluding commissions and margin interest, the $7,000 received represents a $2,000 profit, or a 40% return on the investor’s initial stake of $5,000. Had the investor not used margin, and invested only the $5,000 on hand as opposed to the $10,000 including borrowed funds, the profit would have been only $1,000, or a 20% return on the initial stake.
Scenario 2: Share Price Decreases
If the value of XYZ Corp shares actually declined, then a different scenario plays out. For this example let's assume the brokerage has a minimum maintenance requirement of 35%.
Let's assume the value of XYZ Corp declined from $100 to $75. This reduces the value of the equity in the account to $2,500.
100 x $75 - $5,000 (the margin loan) = $2,500
$2,500 (equity) / $7,500 (account value) = 33.3%
This is below the 35% minimum maintenance requirement. The investor will get a margin call for the amount needed to bring the account back into the compliance with the minimum, or $125.
(0.35 x $7,500) - $2,500 = $125
In response to the margin call, the investor decides to add $125 of cash to the account, raising the equity to $2,625. Unfortunately the shares decline another $15 to $60/share. While this would trigger another margin call (the equity has fallen to $1,125), the investor decides to sell.
((100 x $60) + $125) - $5,000 (margin loan) = $1,125
$1,125 / $6,000 (account value) = 0.1875
After repaying the margin loan, the investor is left with $1,125 from the initial stake as well as the $125 added to the account to cover the first margin call. The investor will have suffered a $4,000 loss, or an 80% loss on their initial equity. If the investor had not used margin, the loss would have been
50 x $40 = $2,000, or 40% of the initial stake.
Risks of Buying on Margin
Using margin to buy stocks carries above-average risks for investors. When using cash to buy stocks, an investor’s maximum loss is limited to the initial investment (including commissions). With stocks bought on margin, however, the investor could lose all of their initial stake and still have to repay the money borrowed from the brokerage.
Tip: Volatile stocks whose values swing wildly within a day can trigger unexpected margin calls. Investors should be particularly careful when using margin to buy volatile stocks.
Other potential costs related to margin trading include:
- Liquidation: Being forced to sell shares at a loss to meet margin calls/repay margin loans
- Unexpected tax liabilities from selling securities to meet margin calls and/or repay margin loans
- Credit risk: Possible negative impacts to an investor’s credit rating if the brokerage must pursue the investor for loan repayment
Important: If forced sales by brokerages to fulfill a margin call are not sufficient to repay the margin loan, the brokerage will expect the investor to make up the difference, resorting to legal collections if necessary.
The maintenance requirement is the minimum amount of equity an investor must have relative to the account value. Maintenance requirements are established by regulators, exchanges, and brokerages.
The margin rate is the interest rate charged by the brokerage for funds borrowed for buying stocks on margin. Rates vary from brokerage to brokerage, and many brokerages will change lower rates to investors with larger account balances at the brokerage. For many investors, margin rates will be similar to HELOC rates and lower than the rates on personal credit lines, and virtually always lower than the rates on credit cards.
A related term, the broker’s call (or broker call rate) refers to the interest rate that banks charge brokerages for funds used to finance margin loans; brokerages often price their margin rates on a “broker call plus” basis.
Leverage essentially means increased exposure; margin is a form of leverage, but not all leverage requires margin. Investors buying options or futures contracts are employing leverage, but are not borrowing funds as investors do when they buy stocks on margin.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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