Regarding trading and investing, the margin is the borrowed money some traders use to execute their strategy. Buying assets on margin can help magnify your gains and returns—but it can do the same with your losses.
When you buy on margin, you purchase assets using the money you borrow from your broker. Read on to learn more about what it means to trade on margin, the definition of margin trading, and how buying on margin works.
Margin trading might seem more complicated than other ways to invest in the stock market, but it’s a method that many investors favor — especially experienced investors.
Table of Contents
- What Is Margin Trading?
- How Does Trading on Margin Work?
- The Language of Trading on Margin
- Potential Benefits of Margin Trading
- Potential Risks of Margin Trading
- How to Get Started With Margin Trading
- Does Margin Trading Work for Your Goals?
- FAQ
What Is Margin Trading?
Margin trading, or “buying on margin,” is an advanced investment strategy in which you trade securities using money borrowed from your broker to magnify your return. Margin is essentially a loan where you can borrow up to 50% of your security purchase, and as with most loans, a margin loan comes with an interest rate and collateral.
Margin trading is similar to “buying on credit.” Using a margin for a trade is also known as leverage.
The margin interest rate depends on how much you borrow and your relationship with the broker. Cash and stock are popular forms of collateral typically used by margin traders based on the account’s size and type of security being traded. Traders must also maintain a margin balance, the maintenance margin, in their budgets to cover potential losses. We cover the topics of interest, maintenance margin, and other details in the section “How Does Trading on Margin Work?”
Margin trading is a bit more complicated (and risky) than other ways to invest in the stock market. Still, it’s a method that numerous traders favor — especially the more experienced ones.
Below, we dive into how using margin differs from other investing methods. We explore the potential advantages and risks of margin trading, the regulations, and the ins and outs. And if you feel ready to use this technique, we will discuss how to get started.
How Does Margin Trading Work?
While margin trading seems straightforward, it’s essential to understand all the parameters. Your broker is the intermediary between your account and counterparty for all trades.
Whenever you enter a buy or sell trade on your account, your broker electronically executes that trade with a counterparty in the market and transfers that security into/out of your account once the transaction is completed.
To execute trades for a standard cash account vs. a margin account, your broker directly withdraws funds for cash trade. Thus, every cash trade is secured 100% by the money you’ve already deposited, entailing no risk to your broker.
By contrast, with margin accounts, part of each trade is secured by cash, known as the initial margin, while the rest is covered with funds you borrow from your broker.
Consequently, while margin trading affords you more buying power than you could otherwise achieve with cash alone, the additional risk means that you’ll always need to maintain a minimum level of collateral to meet margin requirements.
While margin requirements can vary by broker, we’ve defined and outlined the minimums mandated by financial regulators.
| Term | Amount | Definition |
|---|---|---|
| Minimum margin | $2,000 | Percentage of your holdings that need to be covered by equity |
| Initial margin | 50% | Percentage of a security purchase that needs to be funded by cash |
| Maintenance margin | 25% | Percentage of your holdings that needs to be covered by equity |
Increase your buying power with a margin.
Be careful; don’t live off “Cocktails and Dreams” on the margin!
Margin Trading Example
To illustrate how margin trading works, we’ve presented an example below.
Imagine you open a margin account with $2,000 at a brokerage firm.
In this example, you have a high conviction bet on a stock trading at $200 per share. With $2,000 cash, usually, you can only buy ten shares at the current market price.
However, with your margin account’s 50% initial margin requirement, you can obtain a $2,000 margin loan on top of your $2,000 cash investment, which boosts your buying power to $4,000. This allows you to double your purchase to 20 shares.
Your position breakdown is as follows:
• $4,000 market value (20 shares); financed with $2,000 cash equity and a $2,000 margin loan.
Use the following formula to calculate your equity value:
E = MV – L
Where,
E = Equity value
MV = Market Value of holdings = Stock price X Number of Shares
L = amount of Margin Loan
Using the formula above, we get the following after substituting $4,000 for market value and $2,000 for the margin loan.
E = $4,000 – $2,000
E = $2,000, equal to the cash equity you contributed at purchase.
Assuming a year has passed since you purchased the stock, gains or losses can be calculated as follows.
Calculating Gain
If the value of the stock were to increase to $250 after one year, the market value of the 20 shares you purchased would rise to 20 shares X $250 = $5,000. Your position breakdown would be as follows:
• $5,000 market value (20 shares)
• Equity value rises from $2,000 to $3,000
• Margin loan balance remains $2,000
$3,000 equity after one year – $2,000 initial investment = $1,000 gain on investment
Gain / Initial investment = return
$1,000 / $2,000 = 50% one-year return.
Calculating Loss
In the converse scenario, the stock value in this example declines to $150 after one year; the market value of the 20 shares you purchased would drop to 20 X $150 = $3,000. Your position breakdown would be as follows:
• $3,000 market value (20 shares X $150)
• Equity value drops from $2,000 to $1,000
• Margin loan balance remains $2,000
$1,000 equity after one year – $2,000 initial investment = – $1,000 loss
-$1,000 / $2,000 = – 50% one-year return on investment.
The margin loan balance remains the same in both scenarios, while the equity value takes the entire gain or loss. This is because the investor remains on the hook for the margin loan regardless of whether they gain or lose on the trade.
Bear in mind our example ignores interest expense for simplicity. In an actual margin trade, you would also need to back out any interest expense incurred on the margin loan before calculating your return; this would act as an additional drag on earnings.
The Language of Trading on Margin
As we said above, margin trading is slightly different from other investing methods, such that it has developed its own set of related terms. Before you embark upon margin trading, it might help to familiarize yourself with some of them.
Margin Account
This is the type of brokerage account you’ll need to begin trading on margin. It means the brokerage firm will lend funds for stock purchases.
Financial Industry Regulatory Authority (FINRA)
The Financial Industry Regulatory Authority (FINRA) is a nonprofit agency organized by Congress. This organization oversees margin trading by writing and enforcing rules that govern the industry, ensuring brokerage firms’ compliance with those rules, and educating investors. FINRA’s goal is to help protect investors and regulate brokerages to ensure they’re working in the best interests of American investors.
Minimum Margin
FINRA rules set a dollar amount that must be deposited based on the kind of margin trading to be executed. The amount may vary depending on the purchase amount of the investment and brokerage firm policies. And brokerages might set higher minimums than FINRA does.
Initial Margin
The initial margin for new accounts is set at 50% by Regulation T of the Federal Reserve Board. Under FINRA rules, this amount must be $2,000 or 100% of the purchase price of the margin securities, whichever is less. For example, a $10,000 trade would require an initial margin of $5,000. Some brokerages might even ask for more than 50% as part of the initial margin. This is FINRA’s rule; some brokerages may require a higher minimum margin.
Maintenance Margin
The maintenance margin specifies how much money investors must spend in their margin accounts. According to the U.S. Securities and Exchange Commission (SEC), “FINRA rules require this ‘maintenance requirement’ to be at least 25 percent of the total market value of the securities purchased on margin (that is, ‘margin securities’).” This might mean investors need to add cash to their margin accounts if the price of their investment drops significantly. For short sales, the minimum requirement is $2,000.
Margin Call
A margin call happens when the value of an investor’s margin account dips below the brokerage’s maintenance margin. The “call” is a request for the investor to meet the maintenance margin and usually happens when a security the investor purchased decreases in value. If you get a margin call, you may bring the account up to the minimum amount by depositing more funds or assets into the account or selling off some securities in the statement.
Once you’ve familiarized yourself with margin trading lingo and some basic stock market terms, it might be helpful to understand some potential benefits and risks of margin trading.
Potential Benefits of Margin Trading
• Potential to enhance purchasing power. A primary benefit of margin trading is the potential expansion of an investor’s purchasing power, sometimes exponentially. This could help boost returns if the stock price or other investment with a margin trade increases.
• Possible lower interest rates. Benefits of margin loans might include lower interest rates — other types of loans, such as personal loans — and the lack of a set repayment schedule. Margin loans are meant to be used for investing and generally should not be used for other purposes, although they can be.
• Diversification. You could also use margin trading to diversify your portfolio.
• Selling short. Another potential advantage might be a complicated trading method called short selling. Margin trading might make it possible for you to sell stocks short. Short selling differs from most other investment strategies in that investors make a bet that a stock’s price will fall.
• The rules for short selling with a margin account can get even more complicated than a traditional margin trade. For instance, Regulation T of the Federal Reserve Board requires margin accounts to have 150% of the value of the short sale when the transaction is initiated.
While the benefits of buying more investments — and potentially making more money — might seem appealing to some investors, there are also some potential risks to using margin. It might be worth considering these before you decide if trading on margin is right for you.
Potential Risks of Margin Trading
• Possible loss beyond the initial investment. While a primary benefit of margin trading may be increased buying power, investors could lose more money than initially invested. Unlike a cash account, the traditional way to buy stocks or other investments, losses in a margin account can extend beyond the initial investment.
For example, if an investor purchases $20,000 worth of stock with a cash account, the most they can lose is $20,000. If that same investor uses $10,000 of their own money and a margin — essentially a loan — of $10,000 and the stock loses value, they may owe more than their initial $10,000.
• Possibility of a margin call. Another potential negative aspect of margin trading is getting a margin call. Investors might need to put additional funds into their accounts on short notice if a margin call is triggered because the investment lost value. Moreover, a drop in value might mean an investor needs to sell off some or all of the investment, even at an inopportune time.
• The SEC warns investors to sell some of their stock or deposit more funds to cover a margin call. If you get a margin call, you must deposit more funds, add securities, or sell holdings in your account. If you don’t meet the margin call after several warnings from your broker, the broker has the right to sell all or some current positions to bring the account back up to minimum value.
How to Get Started With Margin Trading
Typically, the first step to starting with margin trading is to open a margin account with a brokerage firm.
Even if you already have a stock or investment account, which is a cash account, you still need to open a margin account because they are regulated differently. First-time margin investors need to deposit at least $2,000 per FINRA rules. If you’re looking to day trade, this dollar figure goes up to $25,000 according to FINRA rules. This is the minimum margin when opening a margin trading account.
FINRA defines a day trade as “the purchase and sale, or the sale and purchase, of the same security on the same day in a margin account.” These higher dollar amounts could be associated with what some have called the “greater risk of day trading.”
Once the margin account has been opened and the minimum margin amount supplied, the SEC advises investors to read the terms of their performance to understand how it will work.
The SEC advises investors to protect themselves by
• Understanding that your broker charges you interest for borrowing money,
• Knowing how the interest will affect the total return on your investments,
• Recognizing that not all securities can be purchased on margin,
• Comprehending the details about how a margin account works. Awareness of possible outcomes should the price of assets purchased on margin decline.
Does Margin Trading Work for Your Goals?
That’s the question most investors will probably need to answer once they’ve learned the lingo, weighed the pros and cons, and figured out how margin trading works.
As with most investing strategies and vehicles, margin trading has a unique set of potential benefits, risks, and rewards.
Margin trading can seem a little more complicated than other investing approaches. As the investor, it is up to you to decide if the potential risks are worth the potential rewards and if this strategy aligns with your goals for the future.
“The Bottom Line”
What is a margin call?
A margin call occurs when investors do not keep the minimum amount in their margin account. Suppose the account balance falls below the minimum amount. In that case, the broker will typically ask the account owner to deposit more funds or assets to meet the minimum requirement.
What is a margin rate?
A margin rate is the interest rate that applies when an investor trades on a margin. Margin rates can vary from broker to broker. Many brokerages use a tiered rate schedule based on the margin loan amount.
How popular is margin trading?
Margin trading as an investment strategy is not particularly popular, but neither is it unpopular. It’s just risky. Because of the potential risks involved, professional traders tend to use it more than individual investors. And it is generally not recommended for beginners.
What happens if you don’t have the money to meet a margin call?
If you get a margin call, you must deposit more funds into your account. If you don’t meet the margin call after several warnings from your broker, the broker has the right to sell all or some current positions to bring the account back up to minimum value.
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.
