What You Need to Know About Margin Trading

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Buying stocks on margin can seem like a great way to make money. If you have a few thousand dollars in your brokerage account, you might qualify to borrow money against your existing stocks at a low interest rate. You can use that borrowed cash to buy even more stock. In theory, this could leverage your returns.

The reality is that margin trading is an inherently risky strategy that can transform even the safest blue-chip stock purchase into a high-stakes gamble. It allows aggressive traders—both individuals and institutions—to buy more shares than they could otherwise afford. When things go according to plan, these investors make a lot of money. When things go south, it can get really ugly, really quickly.

The Definition of Margin

When many traders want to buy a stock, they either deposit the necessary cash into a brokerage account to fund the transaction or they 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 key 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.

The Basics of Margin Trading

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.

Cash Account Differences

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.

Before applying for a margin account, it's important to understand the key differences between these kinds of accounts and a cash account. There are also differences between the loans you'll receive for margin trading and other common types of loans.

All securities in your margin account (stocks, bonds, etc.) are held as collateral for a margin loan. That means, 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.

What a Margin Trade Might Look Like

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.

Margin Trading Scenario 1

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.

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.

The Risks of Buying Stocks on Margin

It's easy to imagine a scenario in which margin trading can result in major losses, but those aren't the only risks associated with this practice.

Failure to cover significant losses on margin trading could ultimately result in bankruptcy.

In some extreme cases, margin trading has exacerbated broader economic issues. In the late 1920s, just before the Great Depression, maintenance requirements averaged just 10%. Brokerage firms would loan $9 for every $1 an investor had deposited. When the stock market started falling and brokers made their margin calls, investors who kept most of their wealth in the stock market couldn't meet maintenance requirements or repay their debt. The brokers then sold stock in these margin accounts to pay off the loans. This created a cycle of selling stocks to pay off loans that contributed to the stock crash.

Margin accounts also open an investor up to something called 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.

In a perfect world, there's no harm done by rehypothecation—everyone honors their debt payments and the collateral never has to be seized. However, 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.

How to Add Margin Trading to Your Account

Getting access to a margin account is fairly easy, granted 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. That means you have to deposit at least $2,000 to qualify for a margin account. Some brokerages may set their minimum margins higher.

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.

The Bottom Line

Margin trading amplifies the performance of a portfolio, for better or worse. There's the potential to make more money, compared to a cash-only stock trade, but margin trading also introduces the possibility that you lose more than you initially invested.

The primary risks are market conditions and time. Prices may fall, even if the investment is already an undervalued stock. It may take a significant amount of time for the price of a stock to recover, resulting in higher interest costs for the margin loan. Meanwhile, investors may have to add funds to their accounts to maintain maintenance requirements, adding to the total cost of their investments.

Article Sources

  1. Securities and Exchange Commission. "Margin: Borrowing Money to Pay for Stocks." Accessed April 15, 2020.

  2. SEC Office of Investor Education and Advocacy. "Margin Account." Accessed April 15, 2020.

  3. Fidelity Investments. "Avoiding and Managing Margin Calls." Accessed April 15, 2020.

  4. SEC Office of Investor Education and Advocacy. "Margin Call." Accessed April 15, 2020.

  5. SEC Office of Investor Education and Advocacy. "Updated Investor Bulletin: Trading in Cash Accounts." Accessed April 15, 2020.

  6. SEC Office of Investor Education and Advocacy. "Investor Bulletin: Understanding Margin Accounts." Accessed April 15, 2020.

  7. Federal Reserve Bank of San Francisco. "Margin Requirements as a Policy Tool?" Accessed April 15, 2020.

  8. Board of Governors of the Federal Reserve System. "The Ins and Outs of Collateral Re-Use." Accessed April 15, 2020.

  9. Financial Industry Regulatory Authority. "Know What Triggers a Margin Call." Accessed April 15, 2020.