Although it’s been available in the brokerage industry for decades, buying stocks on margin ranks up there with short selling as one of the things many investors are most wary about trying. But once you learn the basics of margin—and understand its inherent risks—you might find it to be a valuable addition to add to your trading toolbox.
Buying (or trading) on margin means buying securities with borrowed money. Initial margin requirements are governed by Regulation T—often referred to as “Reg T”. Reg T says that brokers may lend qualified customers up to 50% of the purchase price of a marginable security, with the balance being posted by the customer as cash or securities. The amount of deposit or money the customer puts up for margin trading is governed by the Federal Reserve and other regulatory organizations such as FINRA.
To purchase securities on margin, qualified traders who are approved for margin trading are required to sign a margin agreement so that they can borrow money from the broker to buy securities.
The Margin Trade Number Crunch
Buying on margin is similar to taking out a loan, with some important differences. When you borrow from a lender you are required to post collateral, pay interest, and repay the loan at some point. With margin trading, the collateral is usually other securities in your account, and interest is charged only on securities purchased on margin according to a posted margin rate. To “repay” the margin loan or meet a margin call (more on that later), you can either:
- Deposit additional cash
- Deposit fully paid marginable securities
- Sell securities held on margin in your account
Now let’s take a look at how buying on margin can affect your returns.
Margin can magnify the gains, as well as the losses, on your position. This magnification is known as “leverage,” and is typically expressed as a ratio of the notional value to the amount you put up. In our example here, your leverage ratio is $40,000/$20,000, or 2:1 (also known as “2x”).
Leverage and Risk: This Sword Has Two Edges
If the stock in the example above were to rise from $40 to $45/share, that would be a gain of $5/share, or $5,000. This would be a 25% profit because the gain is based on the $20/share paid for with cash, and excludes the $20/share paid with funds borrowed from the broker.
Of course, leverage can also magnify losses. If the stock were to drop to $35/share, you would be sitting on a 25% loss on the position. And because both profits and losses are magnified with margin, it’s possible to lose more than the initial amount used to purchase the stock. This magnifying effect can lead to a margin call.
You’d Better Take this Call
A margin call occurs when losses on securities exceed a limit set either by a broker or the broker’s regulating body. This "maintenance" margin limit may be increased by the broker without prior notice, but may typically be something like 40%, 35%, 30%, and in some cases as low as 25%, instead of the initial 50% required at the time of purchase.
You can think of Reg T as the requirement for purchasing the position, and think of maintenance as the requirement for keeping the position. If it’s reached, you’re required to deposit more money or fully paid securities, or to sell securities, in order to meet the margin call.
Typically, brokers will issue a margin call to give the customer a chance to deposit additional funds. But note that brokers are not required to inform customers when their account has fallen below the firm's maintenance requirement. Hiding from your broker won’t help. When in a margin call, brokers may have the right to sell securities in a customer's margin account at any time without consulting the customer.
Despite the unique risks associated with margin trading, there are also some unique benefits. The leverage that margin provides can allow you to be more flexible in managing your portfolio. For example, you could use margin to purchase additional securities to further diversify your existing portfolio, or to hedge a portfolio in an effort to potentially reduce risk of loss. Typically margin is used to take a larger position than a cash account would accommodate. As explained, this larger position includes greater risk.
Interested in Margin Privileges?
Qualified margin accounts can get up to twice the purchasing power of a cash account, but with added risk.