Margin trading: what it is and what you need to know
The most common way to buy stocks is to transfer money from your bank account to your brokerage account, then use that money to buy stocks (or mutual funds, bonds, and other securities). However, this is not the only way.
What is margin trading?
Margin trading, or “buying on margin,” means borrowing money from your brokerage firm and using that money to buy stocks. Put simply, you take out a loan, buy stocks with the loaned money, and repay that loan – usually with interest – at a later date.
Buying on margin has some appeal over using cash, but it’s important to understand that with the potential for higher returns, there is also more risk. Margin trading is a form of leverage that investors use to increase their returns. However, if the investment does not go as planned, it means that the losses may also be magnified.
Example of margin buying
Suppose an investor wants to buy 200 shares of a company that is currently trading at $ 30 a share, but it only has $ 3,000 in its brokerage account. She decides to use that money to pay off half (100 shares) and buys the other 100 shares on margin by borrowing $ 3,000 from her brokerage firm, for a total initial investment of $ 6,000.
Now let’s say the stock price goes up 33% to $ 40. This means that the value of his initial investment of $ 6,000 has grown to around $ 8,000. Even if she has to return the borrowed money, she keeps the gains that she helped her achieve. In this case, after returning the $ 3,000, he is left with $ 5,000 – a profit of $ 2,000. If she had only invested her $ 3,000 in cash, her earnings would have been around $ 1,000.
By trading on margin, the investor doubled his profit with the same amount of money.
However, not all investments are winners. In a losing scenario, the stock suffers a hit and the stock price drops from $ 30 to $ 20. The value of her investment drops from $ 6,000 to $ 4,000, and after paying off the loan, she has only $ 1,000 left, a loss of $ 2,000. If she had only invested with her money, her losses would have been only half, to $ 1,000.
What if the stock price soars even higher to, say, $ 10 a share? The total investment is now only worth $ 2,000, but the investor needs $ 3,000 to pay off the loan. Even after selling the remaining shares to pay off the loan, she still owes $ 1,000. This equates to a total loss of $ 4,000 (his initial investment of $ 3,000 plus an additional $ 1,000 to meet the loan conditions).
You read correctly. When you use leverage, it is possible to lose more than your initial investment.
How margin trading works
As the example above illustrates, margin trading can be a risky and expensive business for investors without the know-how and financial means to manage the loan. So let’s take a look at some of the details of margin loans, starting with a few key elements of the loan:
Like a secured loan, a margin loan requires the investor to provide collateral, which acts as a security deposit. The value of assets held in an investor’s account – including cash and investments such as stocks and mutual funds – serves as collateral for the loan. At a minimum, most brokers require investors to keep $ 2,000 in their account to borrow on margin.
The credit limit – the amount an investor is allowed to borrow – is based on the price of the asset purchased and the value of the collateral. Typically, a broker will allow an investor to borrow up to 50% of the purchase price of a stock, regardless of the amount of collateral in the account. Suppose, for example, you want to buy $ 5,000 in shares of a stock and put half of it on margin. You will need to have enough money in the account (aka “initial margin”) to cover the tab’s $ 2,500 to borrow the remaining $ 2,500 on the margin.
Like any loan, the borrower is debited with interest. The brokerage sets the interest rate on the loan by setting a base rate and adding or subtracting a percentage depending on the size of the loan. The larger the margin loan, the lower the margin interest rate. To use an example of a large brokerage house, as of 2020, an investor who wanted to borrow $ 10,000 to $ 24,999 would pay an interest rate of 8.70% on the loan, while an investor borrowing $ 100,000 to $ 249,999 would pay an effective rate of 7.45%. Interest accrues monthly and is applied to the margin balance. When the asset is sold, the proceeds are first used to pay off the margin loan.
While margin loans have some things in common with traditional loans, the devil – and the danger – is in the differences.
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What are the maintenance requirements and margin calls?
With a traditional loan (a home loan for example), the value of the property purchased with the borrowed money has no effect on the conditions of the loan once the papers are signed.
If for a year house sales in the neighborhood have been slow and your favorite real estate search engine’s algorithm says your house is worth less than what you paid for it, it is simply a matter of loss of paper. The bank is not going to raise your interest rate or ask you to reapply for a loan. The lender also won’t force you to sell your house or, if you don’t, own your car and sell it for cash.
But if mortgages worked like margin loans, this is exactly the kind of scenario a homeowner would face.
Margin loans, unlike mortgages, are tied at all times to the constantly fluctuating level of cash and securities (the loan collateral) in an investor’s brokerage account. To comply with the terms of the margin loan, investors must maintain a minimum level of cash and securities in their account, or the broker’s “maintenance level”.
If the value of these securities drops and the collateral falls below the maintenance level (as can happen when any of the stocks in the portfolio fall, including those bought on margin), the broker will issue a “margin call”. .
At this point, an investor has a few hours to a few days to bring the value of the account to the minimum maintenance level. She can do this by depositing more money or selling stocks (or closing option positions) to increase the amount of money in the account.
If you miss the margin call deadline, the broker will decide what stocks or other investments to liquidate to align the account.
Other risks of margin trading
Is the threat of a margin or maintenance call making you nervous? It’s a perfectly reasonable reaction.
Stock values are constantly fluctuating, putting investors at risk of falling below the maintenance level. As an added risk, a brokerage firm can increase the maintenance requirement at any time without having to provide much notice, depending on the fine print of most margin loan agreements.
Regardless of what drives a margin call or causes an investor’s account to fall below the minimum maintenance level, trading on margin can lead to all kinds of financial problems, including:
Being forced to block losses. If hedging a margin call requires you to sell stock, the option of holding a stock to see if it recovers from a loss is not an option.
Short-term sales that trigger a tax bill. Investors who trade in a taxable brokerage account should determine which stocks they are selling to avoid a rise short-term capital gains tax bill. And remember, you don’t have a say in what stocks are sold if it’s up to the broker to bring your account into line with their margin requirements. (Advantage: In some cases, interest on margin loans may be tax deductible from your investment income.)
Loan conditions that undermine investment gains. As with any debt, the math only works in your favor if the investment you make exceeds the interest rate you pay on the loan. This is a relatively high bar with margin lending rates in the range of 7% to 9%.
A blow to your credit. As with a conventional loan, failure to repay the loan according to the terms of the contract can result in a negative rating on the borrower’s credit report.
Exposure to greater losses. As illustrated in the example above, buying on margin can lead to losing more money on a trade than if you were to stick with the money you had on hand.
Handle with Care
Margin loans, like credit cards, can be a useful mobilization tool. For investors who understand the risks and have extensive investment experience, trading on margin can increase profits and open up trading opportunities. Just make sure you heed all the warnings about margin lending and don’t get in until you know exactly what you’re getting into.