What Is Margin Trading?
In a traditional brokerage account, you use your own money to buy securities. With a margin account, you borrow money from your brokerage firm to pay for part of your investment. When you leverage your investments in this manner, your gains are amplified — but so are your losses.
Here’s a look at the basics of buying stocks on margin, including both the benefits and the risks.
What Is Margin Trading?
Margin trading, also known as buying on margin, lets you borrow money to purchase securities. This means you can make larger investments than you’d be able to using your own money. The downside is, you also take on debt, added costs in the form of interest, and additional risk. For this reason, margin trading is better suited for experienced investors.
Two terms are important to know when buying on margin:
- Initial margin: The amount of an investment purchase you have to pay for with cash. On most investments, the initial margin is 50%, meaning that if you buy $10,000 worth of stock, you’ll have to put up at least $5,000 in cash.
- Maintenance margin: The absolute minimum amount of margin you need to keep in your account. The Financial Industry Regulatory Authority, or FINRA, requires that customer equity must never fall below 25% of the value of securities in an account. Most brokerage firms build in a buffer and require clients to keep 30% or 35% maintenance margin at all times.
How Margin Trading Works
To begin, you’ll have to open a margin account. For most securities, your buying power, or the amount of stock you can buy, is twice the amount of your deposit. Thus, if you open a margin account with $5,000, you can buy up to $10,000 of stock. In this scenario, if you borrow the remaining $5,000 from your brokerage firm, you’ll start accruing interest charges on the $5,000 that you borrowed.
The securities act as collateral for the loan, and the brokerage charges you an interest rate. Unlike other types of debt, margin loans don’t have a set repayment schedule, though you’ll have to maintain your account value above a certain threshold.
Buying on Margin Example
First, let’s look at how a stock investment might work when you don’t buy on margin. Suppose you have $5,000 available to buy 100 shares of a $50 stock. After a year, that stock price rises to $70, so your shares are now worth $7,000. You decide to sell and realize a $2,000 profit.
Here’s how it might work when you buy that same stock on margin. In this case, you combine the $5,000 you already have with the $5,000 you borrow on margin for a total investment of $10,000. Now you can buy 200 shares of that $50 stock. A year later, when the stock price reaches $70, your shares are worth $14,000, and you decide to sell the stock.
First, you have to pay back the $5,000, and then you have to pay the interest. If the interest rate is 8%, then that’s another $400 you will have to pay, leaving you with $8,600. Your profit now is $3,600 – a bigger haul than you made when you didn’t buy on margin.
Just keep in mind that it works the other way, too. If the $50 stock you bought falls to $40 after a year, your loss would have been $1,000 without buying on margin — $4,000 ending value minus $5,000 initial investment. But if you borrowed $5,000 to buy 200 shares, you would have lost $2,400 — $8,000 ending value minus $5,000 initial investment, minus $5,000 margin loan, minus $400 interest.
What Is a Maintenance Margin?
The maintenance margin, also known as the maintenance requirement, refers to the minimum amount investors must keep in their accounts after buying securities with money borrowed from a broker. This requirement acts as a buffer to reassure the broker that you can repay your debt, which helps lessen the broker’s risk. It typically calls for at least 25% of the assets in your margin account to be owned outright by you.
What Does a Margin Call Mean?
If the equity in your account falls below the maintenance margin requirement, you’ll face a margin call. A margin call requires one of two actions to immediately increase the equity in your account. The first is to deposit enough money to get your account above the maintenance margin level. The second is to sell enough securities to satisfy the margin call. If you don’t resolve the issue immediately, your brokerage firm might liquidate your securities without your permission.
What Are Some Benefits of Margin Accounts?
The main benefit of a margin account is the upside leverage – your ability to turn more buying power into a greater profit from your investment. That’s not the only upside, though. Margin accounts can also help you avoid selling stocks when the market is down. This usually comes into play when you need cash in a pinch. With a margin account, you can simply take out a margin loan instead of selling a stock before it has a chance to increase in value.
You can even use margin accounts to postpone capital gains taxes. This might happen when you need to finance a large purchase but don’t want to sell an investment and have to pay capital gains on the sale. By taking out a margin loan, you avoid the kind of transaction that would lead to a capital gains tax.
Risks of Margin Accounts
Just as margin accounts can increase your potential profit, the main risk is that they also increase your potential losses – through the bigger investment you made, the loan you have to repay, and the interest on the loan. Other risks include the following:
- Your brokerage firm might initiate the sale of any securities in your account without contacting you to meet a margin call.
- Your brokerage firm might increase its maintenance margin requirements
John Csiszar contributed to the reporting for this article.