What is Margin & Should You Invest On It?

What is Margin & Should You Invest On It?

The Basics

Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you’d be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account in which you trade using the money in the account. By law, your broker is required to obtain your signature to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement.

Any purchase of securities on margin requires providing a deposit equal to part of the purchase price. There is no need to ask for an advance in purchasing shares. The investor merely has to deposit the sum required to cover the margin requirement. The investor may then decide whether to buy on margin, in whole or in part, or whether to pay the total purchase cost. It should be noted, however, that the margin can be used only if there is liquidity in the account.

The amount of margin, or loan, provided for share purchases is determined by the specific loan value of each stock. While some stocks may not provide the right to any loan value, others may be eligible for loans of up to 70% of market value.

In Canada and the United States, shares trading above $3.00 are generally eligible for a loan value of 50% of market value. In general, most shares trading above $5.00 and that qualify for options are eligible for a loan value of – 70%.

Some stocks fail to meet eligibility criteria and provide no right to credit or loan value. This applies in particular to any shares trading at less than $3.00 and to all shares listed on the CDNX in Canada or on the Pink Sheet or OTC BB markets in the United States.

Click here to see a table of Desjardins Online Brokerage’s margin loan values NOTE – This link will open in a new tab.

You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan, until it is fully paid. Second, the overall net margin of your account must remain positive otherwise your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it’s known as a “margin call.” We’ll talk about this in detail in the next section.

Marginable securities in the account are collateral. Borrowing money isn’t without its costs – you’ll also have to pay the interest on your loan. Interest is calculated on a daily basis and posted to your account each month.

The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.

Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater a return you need to break even.

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Loans From Other Sources

In some cases, firms may arrange loans for customers from other sources, and there have been instances of customers making loans to other customers to finance securities trades. A customer that lends money to another customer should be careful to understand the significant additional risks that he or she faces as a result of the loan, and needs to carefully read any loan authorization forms. A lending customer should be aware that such a loan may be unsecured and may not be eligible for protection by the Securities Investor Protection Corporation (SIPC). The firm may not, without direction from the borrowing customer, transfer money from the borrowing customer’s account to the lending customer’s account to repay the loan.

Tools to help make informed trading decisions

Margin calculator View any position’s current margin requirements, calculate the impact of hypothetical trades, and see how price changes can affect your margin requirements and balances. Learn more about the Margin calculator Margin alerts Subscribe to receive margin call notifications and other alerts via email, Active Trader Pro® message center, or mobile device. Sign up for alertsLog In Required

What Do I Need to Know About Reg T and Other Margin Rules?

Under Reg T, a Federal Reserve Board rule, you can borrow up to 50% of the purchase price of securities that can be purchased on margin, also known as “initial margin” (some brokerages require a deposit greater than 50% of the purchase price).

Exchanges and self-regulatory organizations, such as FINRA, have their own margin trading rules, and brokerages can establish their own margin requirements, as long as they are at least as restrictive as Reg T, according to the U.S. Securities and Exchange Commission (SEC). FINRA requires a minimum deposit with a brokerage of $2,000, or 100% of the purchase price, whichever is less. This is known as the “minimum margin.”

Pros Explained

  • Can buy more than your cash account would allow: Your cash account limits you to the cash you have on hand. If there's an investment you're interested in, you can invest significantly more with margin trading.
  • Could realize higher returns by investing borrowed funds: The more stock you buy, the more you can potentially earn. Margin trading amplifies your returns.

Margin call

While the value of the stocks used as collateral for the margin loan fluctuates with the market, the amount you borrowed stays the same. As a result, if the stocks fall, your equity in the position relative to the size of your margin debt will shrink.

This is important to understand, because brokerage firms require that margin traders maintain a certain percentage of equity in the account as collateral against the purchased securities—typically 30% to 35%, depending on the securities and the brokerage firm.2

If your equity falls below the minimum because of market fluctuations, your brokerage firm will issue a margin call (also known as a maintenance call), and you will be required to immediately deposit more cash or marginable securities in your account to bring your equity back up to the required level. 

So, assume you own $5,000 in stock and buy an additional $5,000 on margin. Your equity in the position is $5,000 ($10,000 less $5,000 in margin debt), giving you an equity ratio of 50%. If the value of your stock falls to $6,000, your equity would drop to $1,000 ($6,000 in stock less $5,000 margin debt) for an equity ratio of less than 17%.

If your brokerage firm’s maintenance requirement is 30%, then the account’s minimum equity would be $1,800 (30% of $6,000 = $1,800). Accordingly, you would be required to deposit:

  • $800 in cash ($1,000+$800=$1,800), or
  • $1,143 of fully paid marginable securities (the $800 shortfall divided by [1 –the .30 equity requirement] = $1143), or
  • Or some combination of the two. 

Important details about margin loans

  • Margin loans increase your level of market risk.
  • Your downside is not limited to the collateral value in your margin account.
  • Your brokerage firm may initiate the sale of any securities in your account without contacting you, to meet a margin call.
  • Your brokerage firm may increase its “house” maintenance margin requirements or remove specific securities from the marginable list at any time and is not required to provide you with advance written notice.
  • You are not entitled to an extension of time to meet a margin call.

Triggering a margin call

 

 

 

 Equity

Equity

 

Stock value

Margin loan

$

%

Buy stock for $10,000, half on margin

$10,000

-$5,000

$5,000

50%

Stock falls to $6,000

$6,000

-$5,000

$1,000

17%

Brokerage firms maintenance requirement: 30%

$6,000

$1,800

30%

 

 

Margin call

$800

 

What happens if you don’t meet a margin call? Your brokerage firm may close out positions in your portfolio and isn’t required to consult you first. In fact, in a worst-case scenario it’s possible your brokerage firm would sell all of your shares, leaving you with no shares, yet still owing money.

Again, these examples are based on 50% margin debt, which some investors might consider extreme. If your debt is lower, you also decrease your risk of receiving a margin call. A well-diversified portfolio may also help make margin calls less likely, as you would avoid the risk of having a single position drag down your portfolio.

If you decide to use margin, here are some additional ideas to help you manage your account:

  • Pay margin loan interest regularly.
  • Carefully monitor your investments, equity, and margin loan.
  • Set up your own “trigger point” somewhere above the official margin maintenance requirement, beyond which you will either deposit funds or securities to increase your equity.
  • Be prepared for the possibility of a margin call—have other financial resources in place or predetermine which portion of your portfolio you would sell.
  • NEVER ignore a margin call.

The benefits of margin

When used for investing, margin can magnify your profits—and your losses. Here’s an example of the potential upside. (For simplicity, we’ll ignore trading fees and taxes.)

Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year passes, and that stock rises to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.

A gain without margin

You pay cash for 100 shares of a $50 stock

-$5,000

Stock rises to $70 and you sell 100 shares

$7,000

Your gain

$2,000

Here’s what happens when you add margin into the mix. As we saw above, $5,000 in cash gives you buying power totaling $10,000—your existing cash, plus another $5,000 borrowed on margin from your brokerage firm—allowing you to buy 200 shares of that $50 stock.

A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000, plus $400 of interest,1 which leaves you with $8,600. Of that, $3,600 is profit.

A gain with margin

You pay cash for 100 shares of a $50 stock

-$5,000

You buy another 100 shares on margin

$0

Stock rises to $70 and you sell 200 shares

$14,000

You repay margin loan

-$5,000

You pay margin interest

-$400

Your gain

$3,600

So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 for a gain of 72%.

Ask Yourself These Key Questions

  • Do you know that margin accounts involve a great deal more risk than cash accounts where you fully pay for the securities you purchase? Are you aware you may lose more than the amount of money you initially invested when buying on margin? Can you afford to lose more money than the amount you have invested?

  • Did you take the time to read the margin agreement? Did you ask your broker questions about how a margin account works and whether it’s appropriate for you to trade on margin? Did your broker explain the terms and conditions of the margin agreement?

  • Are you aware of the costs you will be charged on money you borrow from your firm and how these costs affect your overall return?

  • Are you aware that your brokerage firm can sell your securities without notice to you when you don’t have sufficient equity in your margin account?

Recognize the Risks

Margin accounts can be very risky and they are not suitable for everyone. Before opening a margin account, you should fully understand that:

  • You can lose more money than you have invested;
  • You may have to deposit additional cash or securities in your account on short notice to cover market losses;
  • You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
  • Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines. Know that your firm charges you interest for borrowing money and how that will affect the total return on your investments. Be sure to ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.

What Does It Mean to Trade on Margin?

Trading on margin means borrowing money from a brokerage firm in order to carry out trades. When trading on margin, investors first deposit cash that then serves as collateral for the loan and then pay ongoing interest payments on the money they borrow. This loan increases the buying power of investors, allowing them to buy a larger quantity of securities. The securities purchased automatically serve as collateral for the margin loan.

Margin Requirements

The terms on which firms can extend credit for securities transactions are governed by federal regulation and by the rules of FINRA and the securities exchanges. This investor guidance focuses on the requirements for marginable equity securities, which includes most stocks. Some securities cannot be purchased on margin, which means they must be purchased in a cash account, and the customer must deposit 100 percent of the purchase price. In general, under Federal Reserve Board Regulation T, firms can lend a customer up to 50 percent of the total purchase price of a stock for new, or initial, purchases. Assuming the customer does not already have cash or other equity in the account to cover its share of the purchase price, the customer will receive a margin call from the firm. As a result of the margin call, the customer will be required to deposit the other 50 percent of the purchase price.

The rules of FINRA and the exchanges supplement the requirements of Regulation T by placing “maintenance” margin requirements on customer accounts. Under the rules of FINRA and the exchanges, as a general matter, the customer’s equity in the account must not fall below 25 percent of the current market value of the securities in the account. Otherwise, the customer may be required to deposit more funds or securities in order to maintain the equity at the 25 percent level. The failure to do so may cause the firm to force the sale of—or liquidate—the securities in the customer’s account in order to bring the account’s equity back up to the required level.

Maintenance Margin Transaction—Example

For example, if a customer buys $100,000 of securities on Day 1, Regulation T would require the customer to deposit margin of 50 percent or $50,000 in payment for the securities. As a result, the customer’s equity in the margin account is $50,000, and the customer has received a margin loan of $50,000 from the firm. Assume that on Day 2 the market value of the securities falls to $60,000. Under this scenario, the customer’s margin loan from the firm would remain at $50,000, and the customer’s account equity would fall to $10,000 ($60,000 market value less $50,000 loan amount). However, the minimum maintenance margin requirement for the account is 25 percent, meaning that the customer’s equity must not fall below $15,000 ($60,000 market value multiplied by 25 percent). Since the required equity is $15,000, the customer would receive a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). Because of the way the margin rules operate, if the firm liquidated securities in the account to meet the maintenance margin call, it would need to liquidate $20,000 of securities.

How many people use margin for trading?

Many people use margin for trading. According to FINRA, as of May 2021, investors have borrowed $861 billion for margin trading. Investors have $213 billion in their cash accounts and $234 billion in their margin accounts.

What is margin trading?

Buying stocks on margin is essentially borrowing money from your broker to buy securities. That leverages your potential returns, both for the good and the bad, and it’s important for investors to understand the implications and potential consequences of using margin.

First, using margin means paying interest to your broker for the money you’re borrowing. At Fidelity, for example, the interest rate you’ll pay on margin balances up to $24,999 is 8.325%. When you compare that rate to the 9% to 10% potential annual return in stocks, you’ll quickly recognize that you’re taking the risk, but the broker is getting much of the rewards. Because of interest, when you use margin you have to worry about your net profit margin, or your profits after paying interest, which will be less than your investing gains.

Investors should also be aware that brokerage firms have initial margin requirements, or minimum margin requirements, requiring the investor to put a minimum amount in the account before they can borrow from the broker. At Fidelity, you must put in $2,000 to use margin. In order to buy an individual stock, the margin requirement is 50%, meaning if you want to buy $10,000 of a stock, you have to put in $5,000 in equity. There are also maintenance margin requirements of at least 25% equity, which would apply when account values fall, and that rate may be adjusted depending on how the account performs and broader market volatility.

Using margin means paying interest to your broker

Using margin means paying interest to your broker for the money you’re borrowing to purchase stock.

Bottom line

Using borrowed funds to invest can give a major boost to your returns, but it’s important to remember that leverage amplifies negative returns too. For most people, buying on margin won’t make sense and carries too much risk of permanent losses. It’s probably best to leave margin trading to the professionals.

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* Note: Michael Foster wrote a previous version of this story. 

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