What Is Margin?
The margin is the collateral that an investor has to deposit with their broker or exchange to cover the credit risk the holder poses for the broker or the exchange. An investor can create credit risk if they borrow cash from the broker to buy financial instruments, borrow financial instruments to sell them short or enter into a derivative contract.
Buying on margin occurs when an investor buys an asset by borrowing the balance from a broker. Buying on margin refers to the initial payment made to the broker for the asset; the investor uses the marginal securities in their brokerage account as collateral.
In a general business context, the margin is the difference between a product or service’s selling price and the cost of production or the ratio of profit to revenue. Margin can also refer to the portion of the interest rate on an adjustable-rate mortgage (ARM) added to the adjustment-index rate.
KEY TAKEAWAYS
- Margin is the money borrowed from a broker to purchase an investment and is the difference between the total value of an investment and the loan amount.
- Margin trading refers to the practice of using borrowed funds from a broker to trade a financial asset, which forms the collateral for the loan from the broker.
- A margin account is a standard brokerage account in which an investor can use the current cash or securities in their account as collateral for a loan.
- Leverage conferred by margin will tend to amplify both gains and losses. In the event of a loss, a margin call may require your broker to liquidate securities without prior consent.
Understanding Margin and Marging Trading
Margin refers to the amount of equity an investor has in their brokerage account. “To buy on margin” means to use the money borrowed from a broker to purchase securities. You must have a margin account to do so rather than a standard brokerage account. A margin account is a brokerage account in which the broker lends the investor money to buy more securities than what they could otherwise buy with the balance in their account.
Using margin to purchase securities is effectively like using the current cash or securities already in your account as collateral for a loan. The collateralized loan comes with a periodic interest rate that must be paid. The investor is using borrowed money, and therefore both the losses and gains will be magnified as a result. Margin investing can be advantageous in cases where the investor anticipates earning a higher rate of return on the investment than what they are paying in interest on the loan.
For example, if you have an initial margin requirement of 60% for your margin account and want to purchase $10,000 worth of securities, then your margin would be $6,000, and you could borrow the rest from the broker.
IMPORTANT
- The Securities and Exchange Commission has stated that margin accounts “can be very risky and they are not appropriate for everyone”.1
How Margin Trading Works
Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you’d be able to normally.
To trade on margin, you need a margin account. This differs from a regular cash account, where you trade using the money in the account. With a margin account, you deposit cash, which is the collateral for a loan to purchase securities. You can use this to borrow up to 50% of the purchase price of an investment. So if you deposit $5,000, you could buy up to $10,000 in securities.
Your broker will charge interest on your loan, which you must repay. If you sell your securities, the proceeds will pay off your loan first, and you can keep what’s left.
The Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) regulate margin trading with strict rules as to how much you must deposit, how much you can borrow, and how much you must keep in your account.2
Components of Margin Trading
Minimum Margin
By law, your broker must obtain your consent to open a margin account. The margin account may be part of your standard account opening agreement or a separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin.2
Initial Margin
Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of your deposit purchase price is known as the initial margin. It’s essential to know that you don’t have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.2
You can keep your loan as long as you want, provided you fulfill your obligations, such as paying interest on time on the borrowed funds. When you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid.
Maintenance Margin and Margin Call
There is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it’s known as a margin call. A margin call is effectively a demand from your brokerage for you to add money to your account or close out positions to bring your account back to the required level. If you do not meet the margin call, your brokerage firm can close out any open positions to bring the account back up to the minimum value. Your brokerage firm can do this without your approval and can choose which position(s) to liquidate.
In addition, your brokerage firm can charge you a commission for the transaction(s). You are responsible for any losses sustained during this process, and your brokerage firm may liquidate enough shares or contracts to exceed the initial margin requirement.
Special Considerations
Because using margin is a form of borrowing money, it comes with costs, and marginable securities in the account are collateral. The primary cost is the interest you have to pay on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on. Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.
Not all stocks qualify to be bought on margin. The Federal Reserve Board regulates which stocks are marginal.3 As a rule of thumb, brokers will not allow customers to purchase penny stocks or initial public offerings (IPOs) on the margin because of the day-to-day risks involved with these types of stocks. Individual brokerages can also decide not to margin certain stocks, so check with them to see what restrictions exist on your margin account.
FAST FACT
- Significant margin calls may have a domino effect on other investors. Should a single major investor face a significant margin call, their forced liquidation may decrease the value of the securities held as collateral by other margin traders, putting these investors at risk of a margin call of their own.
Advantages and Disadvantages of Margin Trading
Advantages
- This may result in more significant gains due to leverage
- Increases purchasing power
- Often has more flexibility than other types of loans
- Maybe a self-fulfilling opportunity cycle where increases in collateral value further increase leverage opportunities
Disadvantages
- This may result in more significant losses due to leverage
- Incurs account fees and interest charges
- This may result in margin calls that require additional equity investments
- May result in forced liquidations which result in the sale of securities (often at a loss)
Advantages
The primary reason investors margin trade is to capitalize on leverage. Margin trading centers increase purchasing power by increasing the capital available to purchase securities. Instead of buying securities with money they own, investors can buy more securities using their capital as collateral for loans greater than their capital on hand.
For this reason, margin trading can amplify profits. Again, with more securities in hand, increases in value have greater consequential outcomes because you’re more heavily invested using debt. On the same note, if the value of the securities posted as collateral also increases, you may be able to utilize leverage further as your collateral basis has increased.
Margin trading is also usually more flexible than other types of loans. There may not be a fixed repayment schedule, and your broker’s maintenance margin requirements may be simple or automated. For most margin accounts, the loan is open until the securities are sold, in which final payments are often due to the borrower.
Disadvantages
If investors primarily enter into margin trading to amplify gains, they must know that margin trading also amplifies losses. Should the value of securities bought on margin rapidly decline, an investor may owe their initial equity investment and additional capital to lenders. Margin trading also comes at a cost; brokers often charge interest expenses, and these fees are assessed regardless of how well (or poorly) your margin account performs.
Because there are margin and equity requirements, investors may face a margin call. This is a requirement from the broker to deposit additional funds into their margin account due to the decreased equity value of securities being held. Investors must be mindful of needing this additional capital on hand to satisfy the margin call.
Should investors not be able to contribute additional equity or if the value of an account drops so fast it breaches certain margin requirements, a forced liquidation may occur. This forced liquidation will sell the securities purchased on margin and may result in losses to satisfy the broker’s requirement.
Example of Margin
Let’s say that you deposit $10,000 in your margin account. Because you put up 50% of the purchase price, this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and haven’t tapped into your margin. You start borrowing money only when you buy more than $10,000 in securities.
Note that the buying power of a margin account changes daily depending on the price movement of the marginal securities in the account.
Other Uses of Margin
Accounting Margin
In business accounting, margin refers to the difference between revenue and expenses, where businesses typically track their gross profit margins, operating margins, and net profit margins. The gross profit margin measures the relationship between a company’s revenues and the cost of goods sold (COGS). Operating profit margin considers COGS and operating expenses and compares them with revenue, and net profit margin considers all these expenses, taxes, and interest.
Margin in Mortgage Lending
Adjustable-rate mortgages (ARM) offer a fixed interest rate for an introductory period of time, and then the rate adjusts. The bank adds a margin to an established index to determine the new rate. In most cases, the margin stays the same throughout the life of the loan, but the index rate changes. To understand this more clearly, imagine a mortgage with an adjustable rate that has a margin of 4% and is indexed to the Treasury Index. If the Treasury Index is 6%, the interest rate on the mortgage is the 6% index rate plus the 4% margin, or 10%.45
What Does It Mean to Trade on Margin?
Trading on margin means borrowing money from a brokerage firm to carry out trades. When trading on margin, investors first deposit cash that serves as collateral for the loan and then pay ongoing interest payments on the money they borrow. This loan increases investors’ buying power, allowing them to buy more securities. The securities purchased automatically serve as collateral for the margin loan.
What Is a Margin Call?
A margin call is a scenario in which a broker who had previously extended a margin loan to an investor sends a notice to that investor asking them to increase the amount of collateral in their margin account. When faced with a margin call, investors often need to deposit additional cash into their account, sometimes by selling other securities. If the investor refuses to do so, the broker can forcefully sell the investor’s positions to raise the necessary funds. Many investors fear margin calls because they can force investors to sell positions at unfavorable prices.
What Are Some Other Meanings of the Term Margin?
The term margin also has other uses in finance outside of margin lending. For example, it is used as a catch-all term to refer to various profit margins, such as the gross profit margin, pre-tax profit margin, and net profit margin. The term is also sometimes used to refer to interest rates or risk premiums.
What Are the Risks of Trading on Margin?
When investing on margin, the investor risks losing more money than what they deposited into the margin account. This may occur when the value of the securities held declines, requiring the investor to either provide additional funds or incur a forced sale of the securities.
The Bottom Line
Investors looking to amplify gain and loss potential on trades may consider trading on margin. Margin trading is the practice of borrowing money, depositing cash to serve as collateral, and entering into trades using borrowed funds. Using debt and leverage, the margin may result in higher profits than what could have been invested should the investor only use their personal money. On the other hand, should security values decline, an investor may be faced with owing more money than what they offered as collateral.
- U.S. Securities and Exchange Commission. “Investor Bulletin: Understanding Margin Accounts.“
- Financial Industry Regulatory Authority. “4210, Margin Requirements.”
- Federal Reserve Board. “Compliance Guide to Small Entities Regulation U: Credit by Banks or Persons other than Brokers or Dealers for the Purpose of Purchasing or Carrying Margin Stocks.”
- U.S. Department of Housing and Urban Development. “Adjustable Rate Mortgages (ARM).”
- Consumer Financial Protection Bureau. “For an Adjustable-Rate Mortgage (ARM), What are the Index and Margin, and How Do They Work?“
Note: ZPEnterprises is not a licensed investor/financial advisor, but we are trying to share awareness of financial topics. Please do further research and work with a licensed financial advisor.
