Margin investing, or borrowing money from a broker to buy securities, comes with big risks and rewards. Buying on margin can amplify gains when the price of a security such as a stock is rising, but it can also magnify losses when that security falls.
There are rules set by federal agencies and regulatory organizations that stipulate how much you can borrow, as well as how much of a balance you must maintain in a margin account.
Interest is charged on a margin loan, meaning any profits still come with costs.
Beware of margin calls. If you buy on margin and the security’s price then drops too low, you might be subject to a margin call, or an alert from your brokerage that additional cash or marginable securities must be deposited, or existing securities must be sold, to meet the minimum equity required. If you are unable to meet the call, securities in your account can be sold. During periods of extreme volatility, however, a brokerage firm may sell your securities to meet a margin call without notifying you in advance.
It is easier than ever to buy securities. During periods of volatility in financial markets, it can be tempting to dive right in. But there are times when an investor might not have enough cash when a buying opportunity emerges.
Margin investing is the practice of borrowing money from a brokerage firm to make investments. Traders tap this to increase buying power, and then pay the sum borrowed back at a later date of their choosing. But the practice comes with significant risks and steep losses can accumulate quickly. That means inexperienced investors should take caution.
What is margin trading?
When you trade on margin, you are borrowing money to buy more of a security—such as a stock, bond or exchange-traded fund—betting that its price will rise. The margin loan comes from your brokerage firm and works similarly to other lines of credit. That means you use the securities in your account as collateral, and the brokerage firm can sell them if you aren’t able to meet the terms of the loan.
How to buy on margin
In order to trade on margin, you must first open an account with a brokerage. Then, to be eligible for margin loans, you must apply and be approved by the firm. The application will typically ask you for employment details and financial information, such as your annual income. Once you are approved, you can take out a margin loan at any time without needing to submit additional applications.
Federal agencies and regulatory organizations have established rules for margin accounts, though brokerage firms may enact more stringent requirements. Some of the minimum requirements include:
- How much can be borrowed: Under the Federal Reserve Board’s Regulation T, brokerage firms can lend you up to 50% of the total purchase price of most equity securities. For example, if you want to buy $10,000 of stock in Company X, you would need to use $5,000 of your own money, and the additional $5,000 would come from the margin loan. Other types of securities may have different requirements.
- The initial requirement: Generally, the Financial Industry Regulatory Authority requires an initial margin for all investors: a deposit of $2,000 in the margin account—or the equivalent value in securities—before you can begin purchasing securities on margin. For pattern day traders, a minimum equity amount of $25,000 is required. Finra defines a “pattern day trader” as someone who executes four or more “day trades” within five business days.
- How much money must be maintained: Once a security is purchased on margin, Finra generally requires a “maintenance margin,” meaning that the equity in your margin account must not fall below 25% of the current market value of the securities in your account. Some brokerages often require larger maintenance margins, such as 30% or higher. If the minimum maintenance requirement is not maintained, you may be subject to a margin call, or an alert from your brokerage firm to increase the equity in your account. Some brokerages may require prompt action, while others may allow several days to meet the call.
For example, you purchase $10,000 worth of shares in Company X by borrowing $5,000 on margin. At the time of purchase, the shares are priced at $10, so you own 1,000 shares.
If Company X’s stock price drops to $8 a share, the market value of the investment falls to $8,000. As a result, the amount of equity in your account—or the amount you own after accounting for what is owed to the brokerage—is $3,000. If your brokerage sets the maintenance margin at 25% of the value of the securities, you would need to maintain $2,000 in the account. At $8 a share, you would have enough equity in your account to meet the maintenance requirement.
But if the stock plummeted to $5.50 a share, the investment’s value would drop to $5,500, meaning that you only have $500 in equity. That’s not enough to satisfy the maintenance margin requirement of $1,375 (25% of the current $5,500 value), and as a result, the brokerage may issue a margin call. In this instance, you would have to deposit $875 in cash to meet it. Fully paid, marginable securities can also be deposited into the account or you could sell securities to cover the shortfall.
The pros and cons of buying on margin
Margin investing can offer you significant benefits. But the strategy carries significant risks.
“When you’re buying securities with borrowed funds, on one hand, you can magnify your gains, but on the other hand, there’s the potential that you magnify your losses,” said Gerri Walsh, senior vice president of investor education at Finra. “Knowing that you can lose more money than you actually deposit into a margin account is one of the biggest risks that investors need to understand.”
Wealth managers and investors say there are advantages to margin investing—namely, the ability to have more buying power without having to sell other securities to raise cash.
Continuing with the example above, imagine that after purchasing $10,000 of Company X stock (1,000 shares for $10 each), using a $5,000 margin loan, the stock price surges to $25. Then, you sell the shares for $25,000. You must return the $5,000, in addition to the interest charged on the loan, to the brokerage firm. That leaves you with $19,500 if the interest was $500—$14,500 of which was profit after putting in $5,000 upfront.
In contrast, if you had purchased $5,000 of Company X without using a margin loan (500 shares for $10) and the share price had increased to $25, your investment would be worth $12,500—yielding a $7,500 profit after you sell.
Investors say there are other benefits. So long as you are able to maintain enough equity to meet your maintenance margin requirement, there is no set schedule for returning the margin loan. Additionally, interest rates for margin loans tend to be less expensive than other forms of lending, such as a credit-card loan.
Margin loans can also be used for purposes beyond investing. Some investors use margin loans to help with major consumer purchases because of the lower interest rates.
Even with the potential for big gains, margin investing also offers the possibility for significant losses—even when you are not confronted with a margin call.
Extending the examples above, imagine that shares of Company X fall to $8 from your initial purchase price of $10. In this scenario, you had similarly used $5,000 of your own cash, plus a $5,000 margin loan to purchase 1,000 shares for $10,000.
Even though you have enough equity in your account to avoid a margin call, you still choose to sell your investment for $8,000. After paying the loan back, plus $500 in interest, you are left with $2,500—meaning you lost half of your initial $5,000 cash investment.
However, had you not tapped a margin loan and instead purchased only 500 shares for $10, your losses would be less severe. When selling at $8 a share, you receive $4,000 from the sale. That’s a loss of $1,000 from your initial cash investment, less than what was lost using a margin loan.
As seen above, one of the disadvantages of margin investing is that additional costs are also incurred from interest on the loan. Interest rates will vary depending on the amount of money you borrow. For loans less than $25,000, interest rates across the industry tend to currently hover around 8%, but rates typically decline as the amount borrowed increases. Robinhood Markets Inc. recently lowered its annual margin interest rate for eligible customers to a flat 2.5% on any amount used above $1,000.
Other risks exist. Many firms will attempt to notify you of margin calls, but they are not required to do so, according to Finra. You are also not entitled to an extension of time to meet a margin call, and in cases of significant market volatility, a broker can take immediate action to sell securities in your account. And when a broker sells your securities to meet the maintenance margin requirement, you do not get to choose what gets sold.
Additionally, brokerage firms may increase their maintenance margin requirements at any time. It is important to read the client agreement from your brokerage before trading on margin.
“Margin is almost like a weapon,” said Dennis Notchick, a private wealth advisor at Stratos Wealth Advisors. “And you have to really know when to use it properly.”
- Investor Bulletin: Understanding Margin Accounts: An investor bulletin from the SEC’s Office of Investor Education and Advocacy that explains the risks and rules surrounding margin investing.
- BrokerCheck by Finra: A free tool from Finra that allows users to research brokers and brokerage firms, as well as investment advisers. The website provides information about licensing and details complaints that may have been filed against them.
- Smart Investing Courses from Finra: A series of e-learning modules from Finra designed to boost investing knowledge and skills.
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