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.
Learn More:
Leverage and Its Impact on Returns
You’ll also hear the word leverage when people are talking about margin trading. Leverage is when you borrow money in order to invest in something.
For example; If you use 3:1 leverage when trading stocks — you can make 3x as much if the stock price goes up, but can also lose 3x more if the price goes down.
Margin Requirements and Regulations
You can’t just take out a margin loan from your broker. There are requirements you must meet first:
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.
Margin accounts are regulated by the Securities and Exchange Commission (SEC) and FINRA, detailing deposit requirements, account minimums and how much you’re able to borrow.
Key Terms in Margin Trading
- Margin account: The account used for depositing initial margin and executing leveraged trades.
- Margin call: A margin call happens when the value of your account falls below the maintenance margin amount. To stop your broker from selling your securities to cover the difference (liquidation), you’ll need to deposit extra funds.
- Maintenance margin: This is the minimum balance required to avoid liquidation
- Liquidation: If you can’t meet a margin call, your broker will sell some or all of your investments to bring your account back to the required level of maintenance margin.
How to Open a Margin Account
You can open a margin account at any broker that offers one. Here’s how it works:
Choosing the Right Broker for Margin Trading
Broker requirements and initial margin deposit requirements vary by broker. If you’re looking to open a margin account, you’ll want to review broker requirements, deposit amounts, interest rates and trading tools.
Make sure to review the broker’s fees and costs related to margin trading. Additionally, familiarize yourself with the margin policies, such as when a margin call may be triggered and how to manage the maintenance margin to keep your account in good standing.
Broker Requirements and Application Process
Most brokers have minimum requirements you must meet to open a margin account. FINRA requires depositing at least $2,000 to open a margin account, while some brokers require a lot more. Regulation T margin accounts require having at least 50% maintenance margin in the account, while standard margin accounts only require 25% maintenance margin.
Once you’ve met the broker terms, you can open a margin account, deposit your initial margin and begin trading.
Benefits of Margin Trading
Margin trading can help you:
- Use upside leverage to get a greater profit from the investment.
- Execute advanced trading strategies such as short-selling or options and futures trading
- Keep your stock when the market is down through margin loans
Risks of Margin Trading
Just as margin accounts can increase your potential profit, the main risk is that they also increase your potential losses. If you borrow money on a trade and your investment goes down in price, you’ve just amplified your losses. You’ll also pay daily interest on your margin loan until it’s paid off, costing you even more money.
Other risks include:
- 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 and push you into a margin call.
- A volatile market can quickly erode any gains on a margined account and end up losing you more money in the long-run.
Real-World Examples of Margin Trading
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.
Example 1: Buying Stocks on Margin
If you choose to buy on margin, 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.
Example 2: How a Margin Call Works
Let’s say you invest in a stock that sells for $50 per share. You put $2,000 in a standard margin account and invest at 3:1 leverage. You buy 120 shares for $6,000. If the price of the stocks drops too far you may end up getting a margin call.
For example; If the stock drops below $12.50 per share, your account value drops below the 25% maintenance margin requirement. This could result in a margin call and you’ll be required to add more funds to your account or you or your broker may sell your stocks to make up the difference.
Example 3: Using Margin for Short Selling
If you want to “short” a stock, this requires a substantial margin account. Regulation T requires having at least 150% of the value of the trade in your margin account, or at least 100% of the value of the short position plus 50% additional maintenance margin.
Once you have the margin in place, you can execute a short sale by borrowing shares of a stock from another investor or broker, and selling those shares in the market. Then, after a period of time, you re-purchase the securities and pay them back to the entity you borrowed them from.
The risk with short-selling is that it’s a bet on the direction of the market going down. If the price of the stock rises, you may lose money by being forced to repurchase stocks at a higher prices to return them to their owner.
Vance Cariaga contributed to the reporting of this article.