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The most common way to buy stocks is to transfer money from your bank account to your brokerage account, then use that cash to buy stocks (or mutual funds, bonds and other securities). However, that’s not the only way.
What is margin trading?
Margin trading, or “buying on margin,” means borrowing money from your brokerage company, and using that money to buy stocks. Put simply, you’re taking out a loan, buying stocks with the lent money, and repaying that loan — typically with interest — at a later date.
Buying on margin has some serious appeal compared with using cash, but it’s important to understand that with the potential for higher returns, there’s also more risk. Margin trading is a form of leverage, which investors use to magnify their returns. However, if the investment doesn’t go as planned, that means losses can be magnified, too.
» Learn more about the differences. Margin accounts vs. cash accounts
Buying on margin example
Let’s say an investor wants to purchase 200 shares of a company that’s currently trading for $30 a share, but she only has $3,000 in her brokerage account. She decides to use that cash to pay for half (100 shares) and she 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 share price rises 33% to $40. That means the value of her initial $6,000 investment grew to about $8,000. Even though she has to return the borrowed money, she gets to keep the gains it helped her achieve. In this case, after she returns the $3,000, she's left with $5,000 — a $2,000 profit. Had she invested only her $3,000 in cash, her gains would have been about $1,000.
By trading on margin, the investor doubled her profit with the same amount of cash.
Not every investment is a winner, however. In a losing scenario, the stock takes a hit and the share price drops from $30 to $20. The value of her investment falls from $6,000 to $4,000, and after she repays the loan, she has just $1,000 — a $2,000 loss. Had she invested with only her cash, her losses would only be half that, at $1,000.
And if the stock price spirals even further to, say, $10 a share? The total investment is now worth just $2,000, but the investor needs $3,000 to pay off the loan. Even after she sells the remaining shares to pay down the loan, she still owes an additional $1,000. That amounts to a total loss of $4,000 (her original $3,000 investment plus an additional $1,000 to satisfy the terms of the loan).
You read that right. When using leverage, it’s possible to lose more than your initial investment.
How margin trading works
As the example above illustrates, margin trading can be risky and pricey business for investors without the know-how and financial means to handle the loan. So let’s dive into some of the details of margin loans, starting with a few key components of the loan:
Like a secured loan, a margin loan requires the investor to provide collateral, which acts like a security deposit. The value of the assets held in an investor’s account — including cash and any investments such as stocks and mutual funds — serve as collateral for the loan. At a minimum, most brokers require investors to maintain $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 being purchased and the value of the collateral. Typically a broker will permit an investor to borrow up to 50% of the purchase price of a stock up to whatever the amount in collateral is in the account. Say, for example, you want to purchase $5,000 in shares of a stock and put half of that on margin. You’ll need to have enough cash in the account (aka “initial margin”) to cover $2,500 of the tab to borrow the other $2,500 on margin.
Like any loan, the borrower is charged interest. The brokerage sets the interest rate for the loan by establishing a base rate and either adding or subtracting a percentage based on the size of the loan. The larger the margin loan, the lower the margin interest rate. To use an example from one major brokerage, as of 2020, an investor who wanted to borrow $10,000 to $24,999 would pay an 8.70% interest rate on the loan, whereas 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, proceeds first go to pay down the margin loan.
Although margin loans have some things in common with traditional loans, the devil — and danger — is in the differences.
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What are maintenance requirements and margin calls?
With a traditional loan (a mortgage, for example), the value of the asset purchased with borrowed money has no bearing on the terms of the loan once the paperwork is signed.
If one year home sales in the neighborhood are sluggish and the algorithm on your favorite real estate search engine says that your house is worth less than what you paid for it, that’s merely a paper loss. The bank isn’t going to raise your interest rate or ask you to reapply for a loan. Nor will the lender force you to sell your house, or if you won’t do that, possess your car and sell it for cash.
But if mortgages worked like margin loans, that’s exactly the kind of scenario that a homeowner would face.
Margin loans, unlike mortgages, are tethered at all times to the constantly fluctuating level of cash and securities (the loan’s 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 those securities dips and the collateral falls below the maintenance level (as can happen when any of the stocks in the portfolio drop, including the ones purchased on margin), the broker will issue a “margin call.”
At that point an investor has from a few hours to a few days to bring the account value up to the minimum maintenance level. She can do that by depositing more cash or selling equities (or closing option positions) to increase the amount of cash in the account.
Miss the margin call deadline, and the broker will decide which stocks or other investments to liquidate to bring the account in line.
Other risks of margin trading
Does the threat of a margin or maintenance call make you nervous? That’s a perfectly reasonable reaction.
Stock values are constantly fluctuating, putting investors in danger of falling below the maintenance level. As an added risk, a brokerage firm can raise the maintenance requirement at any time without having to provide much notice, according to the fine print of most margin loan agreements.
Regardless of what spurs a margin call or causes an investor’s account to fall short of the minimum maintenance level, margin trading can lead to all sorts of financial jams, including:
Being forced to lock in losses. If covering a margin call requires you to sell off shares, the opportunity to hold onto a stock to see if it recovers from a loss is off the table.
Short-term sales that trigger a tax bill. Investors trading in a taxable brokerage account need to consider which shares of what stock they put up for sale to avoid a higher short-term capital gains tax bill. And remember, you don’t have a say in which equities are sold if it’s left to the broker to bring your account in line with its margin requirements. (On the plus side: In some cases interest on margin loans may be tax deductible against your investment income.)
Loan terms that gut investment gains. As with any debt, the math only works in your favor if the investment you’re making outearns the interest rate you’re paying on the loan.
A hit to your credit. Like with a conventional loan, failure to pay back the loan according to the terms of the contract can lead to a negative mark 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 you would have if you stuck with the cash you had on hand.
Handle with care
Margin loans, like credit cards, can be a helpful leveraging tool. For investors who understand the risks and have ample investing experience, margin trading can enhance profits and open up trading opportunities. Just be sure to heed all of the margin loan warnings and don’t get in until you know exactly what you’re getting into.
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