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How to trade using margin

Using your securities to create leverage has the opportunity to amplify returns—and risks.

  • Active Trader News
  • – 10/17/2013
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Trading on margin enables you to leverage securities you already own to purchase additional securities, sell securities short, or access a line of credit. But beware: Using margin is only for experienced investors who are fully aware of the potential risks.

What is margin?

Buying on margin, also known as borrowing on margin or using margin, involves purchasing securities partially with funds that are borrowed from a broker. For example, say you wanted to purchase $10,000 worth of XYZ Company. You could invest $5,000 of your own assets and use a margin loan to buy an additional $5,000, for a total investment of $10,000.

Using margin

To qualify, you must complete a margin agreement. If approved, margin is established on your brokerage account.

When a margin position is established, you become subject to certain requirements, such as the maintenance margin which is the compulsory minimum equity balance needed in a margin account. The purchased securities serve as collateral for the loan from the broker, and depending on the actual performance of the position, you may be required to deposit additional funds to cover the loan.

Why use margin?

Suppose the share price of XYZ Company gained 20% over the next six months. The value of your shares would increase to $12,000. You might then sell the stock and pay off the $5,000 margin loan, as well as the margin interest. That would leave you with $7,000 (less the margin interest charged to the account, resulting in a 30% return on your initial $5,000 investment). Note that this example does not include the impact of taxes and commissions.

Margin loans have several other advantages as well:

  • Convenience. Once approved, you can access a margin loan immediately, without new forms or application fees.
  • Low interest rates. Margin rates, which typically are tied to movement in the federal funds target rate, are competitive with rates on home equity loans.
  • Repayment flexibility. So long as your debt doesn't exceed the allowed percentage of your account balance, you can pay it back on your schedule.
  • Tax-deductible interest. The interest that accrues in the account may offset taxable income. Consult your tax adviser for details regarding your particular situation.

These benefits can also make margin loans worth considering for certain non-investment purposes, albeit in infrequent circumstances. A margin account may serve as backup liquidity as part of your financial contingency planning, a quick source of bridge financing for a time-sensitive real estate purchase, or as a way to meet expenses such as health care costs or college tuition, without selling securities and incurring capital gains taxes.

Beware of the risks

While margin loans can be useful, they have the potential to be misused. First, margin borrowing has all the hazards that always accompany taking on debt — including interest payments and reduced flexibility for future income.

Your brokerage firm will require you to maintain equity in the account worth a specific percentage of its overall value. Fidelity, for instance, typically requires 30% minimum equity on long positions.

If your collateral dips below that threshold, you will receive a margin call, requiring you to place funds in the account immediately, sell securities, or deposit securities into your account. If you fail to meet a margin call, your broker will sell assets from your portfolio to pay down the loan, and is not required to consult you.

Margin poses two primary risks:

  • Leverage risk. Margin can magnify your losses as dramatically as it can boost returns. Stock prices don't always go up. Using our earlier example, suppose instead of posting a gain, the stock drops from $10,000 to $8,000. Your balance would fall to $3,000, less margin interest payments. The stock would fall 20%, but you would suffer more than a 40% loss, excluding other costs.
  • Inability to meet a margin call. If you do not take action to meet a margin call, your brokerage firm will choose which assets to sell from your account and may choose assets that you want to hold on to for their return potential.

When margin might be appropriate

Considering the risks, margin loans may be a way to take advantage of certain opportunities—and, in very specific cases, may actually help you reduce the overall risk in your portfolio.

For instance, an investor may use margin loans to buy employee stock options from his or her company without having to pay cash out of pocket. Here, the investor would not have to use all cash or sell a sufficient amount of securities held to raise enough cash and incur capital gains tax to finance the purchase, and can repay the loan at his or her convenience.

What’s more, he or she has a margin of safety: If the stock is offered at a considerable discount—which can be common in employee stock option programs—it would have to fall considerably before it sinks below the purchase price.

Margin loans can also be useful to diversify a highly concentrated portfolio. A portfolio that has a large block of a single stock, for example, can serve as the collateral in a margin loan to monetize those assets in order to gain diversification.

You can further manage the risk of borrowing on margin by employing the following strategies:

  • Prepare for volatility. Look at your portfolio’s volatility over the last five years. You could consider positioning to withstand similar fluctuations in the overall value of your collateral without falling below your minimum equity requirement.
  • Invest in assets with significant return potential. The securities you buy on margin should, at a minimum, have the potential to earn more than the cost of interest on the loan.
  • Set a personal trigger point. Keep additional financial resources in place to contribute to your margin account when your balance approaches the margin maintenance requirement.
  • Pay interest regularly. Interest charges are posted to your account monthly. Pay them down before they build to unmanageable levels.

Limited margin

Limited margin allows a client to trade on unsettled funds without triggering certain trading restrictions, such as good faith violations in an IRA account. Good faith violations occur when an account purchases a position on unsettled funds, and sells the position before the settlement date of the sale that generated the proceeds.

Limited margin does not allow for borrowing against existing holdings, account leverage, creating cash or margin debits, short selling of securities, or selling naked options. At Fidelity, limited margin is available only for traditional, Roth, rollover, SEP, and Simple IRAs. IRA accounts with an FDIC core are ineligible. So, if clients want limited margin, they may need to change their core for that account. Moreover, clients must have an investment objective of “most aggressive” and should be aware that all day-trade rules will still apply with respect to requirements and liquidations. This includes the $25,000 minimum equity requirement.

Use margin carefully

Trading on margin is not for everyone. You should have a thorough understanding of the requirements and risks involved before seeking qualification for a margin account. However, once you do familiarize yourself with margin, it may help you implement your strategy more effectively.

Learn more

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Margin credit is extended by National Financial Services LLC, member NYSE, SIPC.
As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security.
Past performance is no guarantee of future results.
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Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street. Smithfield. RI 02917
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