Margin trading involves qualifying to borrow money against your existing stocks to buy more stock. In theory, this could increase your returns, but there are risks involved. Learn about how margin trading works and the risks so you can make an informed decision about whether it's right for you.
Definition and Examples of Margin Trading
When many traders want to buy a stock, they either deposit the necessary cash into a brokerage account to fund the transaction or save up for it by collecting dividends, interest, and rent on their existing investments. However, that isn't the only way to buy stock, and the alternative is known as "margin trading."
In the most basic definition, margin trading occurs when an investor borrows money to pay for stocks. Typically, the way it works is your brokerage lends money to you at relatively low rates. In effect, this gives you more buying power for stocks or other eligible securities than your cash alone would provide. Your account, including any assets held within it, then serves as collateral for that loan.
Margin trading involves significantly more risk than standard stock trading in a cash account. Only experienced investors with a high tolerance for risk should consider this strategy.
The catch is that the brokerage isn't going in on this investment with you, and it won't share any of the risks. The brokerage simply lends you money. Regardless of how the stock performs, you will be on the hook for repaying the loan.
The terms and conditions of margin accounts vary but, generally speaking, you shouldn't expect to have the ability to set up payment plans or negotiate the terms of your debt. Your brokerage can legally change the terms at any time, such as how much equity you need to maintain. When you're required to add cash or securities to your account, it's known as a "margin call." If you can't swiftly deposit the cash or stocks to cover the margin call, the brokerage can sell securities within your account at its discretion.
As opposed to a margin account, a cash account requires investors to fully fund a transaction before it executes. You won't acquire debt when using cash accounts, and you can't lose more than the money you deposit into the account.
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.
Pros and Cons of Trading on Margin
Can buy more than your cash account would allow
Could realize higher returns by investing borrowed funds
Could lose money
Risk of rehypothecation
- Can buy more than your cash account would allow: Your cash account limits you to the cash you have on hand. If there's an investment you're interested in, you can invest significantly more with margin trading.
- Could realize higher returns by investing borrowed funds: The more stock you buy, the more you can potentially earn. Margin trading amplifies your returns.
- Could lose money: If you borrow to invest more and that investment loses value, you'll lose significantly more than if you had only used the cash you had on hand.
- Rehypothecation risk: Rehypothecation occurs when a debt-issuer uses the collateral from the debt agreement. With a margin account, your securities are all considered collateral, and your brokerage may choose to use them as collateral for their own transactions and investments. When a piece of collateral is used for multiple transactions, it creates a "collateral chain" that connects more people to the same piece of collateral. Collateral chains add to the fragility of financial markets. If one of those transactions goes bad, it can spark a domino effect that takes down more people than just the two parties involved in a single transaction.
Failure to cover significant losses on margin trading could ultimately result in bankruptcy.
How to Get Margin on Your Account
Getting access to a margin account is fairly easy if you can meet minimum cash requirements. This requirement is known as the minimum margin. The Financial Industry Regulatory Authority (FINRA) has established a baseline minimum margin of $2,000.
Once you meet the minimum margin, all you have to do is fill out the form to apply for a margin account. You can open a new margin account or add margin trading capabilities to your current brokerage account. Either way, the application process will likely be similar.
- Margin trading occurs when you borrow money from your brokerage to pay for stocks using your margin account assets as collateral.
- When you're required to add cash or securities to your account it's known as a margin call.
- If you can't deposit the cash or stocks to cover the margin call, the brokerage can sell securities in your account.
- Margin trading offers the potential to make more money but comes with significant risks, including the possibility of losing more than you invested.
Frequently Asked Questions (FAQs)
What is a margin rate?
Your margin rate is the interest rate your brokerage charges you for your margin loan. The interest rate may vary depending on the size of your margin loan.
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.
What happens when you don't have the money to pay back your debt when margin trading?
If you're unable to meet a margin call, either due to not depositing additional funds or not having enough assets to liquidate in your account, it becomes an unsecured debt that's in default. Your broker can take the measures any creditor can take to collect the debt, including reporting the debt to credit bureaus. It can also sue you for payment.