What Is Margin Trading?

Margin trading involves qualifying to borrow money against your existing stocks to buy more stock. In theory, this could increase your returns, but there are risks involved. Learn about how margin trading works and the risks so you can make an informed decision about whether it’s right for you.

Definition and Examples of Margin Trading

When many traders want to buy a stock, they either deposit the necessary cash into a brokerage account to fund the transaction or save up for it by collecting dividends, interest, and rent on their existing investments. However, that isn’t the only way to buy stock, and the alternative is known as “margin trading.”

In the most basic definition, margin trading occurs when an investor borrows money to pay for stocks.1 Typically, the way it works is your brokerage lends money to you at relatively low rates. In effect, this gives you more buying power for stocks or other eligible securities than your cash alone would provide. Your account, including any assets held within it, then serves as collateral for that loan.

Important:- “Margin trading involves significantly more risk than standard stock trading in a cash account. Only experienced investors with a high tolerance for risk should consider this strategy”

The catch is that the brokerage isn’t going in on this investment with you, and it won’t share any of the risks. The brokerage simply lends you money. Regardless of how the stock performs, you will be on the hook for repaying the loan.

The terms and conditions of margin accounts vary but, generally speaking, you shouldn’t expect to have the ability to set up payment plans or negotiate the terms of your debt. Your brokerage can legally change the terms at any time, such as how much equity you need to maintain. When you’re required to add cash or securities to your account, it’s known as a “margin call.” If you can’t swiftly deposit the cash or stocks to cover the margin call, the brokerage can sell securities within your account at its discretion.

Note:- As opposed to a margin account, a cash account requires investors to fully fund a transaction before it executes. You won’t acquire debt when using cash accounts, and you can’t lose more than the money you deposit into the account.

How Does Margin Trading Work?

Margin trading requires a margin account. This is a separate account from a “cash account,” which is the standard account most investors open when they first start trading.

All securities in your margin account (e.g., stocks, bonds) are held as collateral for a margin loan.6 If you fail to meet a margin call by depositing additional assets, your broker may sell off some or all of your investments until the required equity ratio is restored.4

The maintenance requirement varies from broker to broker.1 This is the ratio between the equity of your holdings and the amount you owe. In other words, it’s how much you can borrow for every dollar you deposit. The brokerage firm has the right to change this at any time. The interest rate your broker charges on margin loans is subject to change as well.

Warning:- It is possible to lose more money than you invest when margin trading. You will be legally responsible for paying any outstanding debt.

Margin Trading Scenario 1

Imagine an investor deposits $10,000 into an otherwise empty margin account. The firm has a 50% maintenance requirement and is currently charging 7% interest on loans under $50,000.

The investor decides to purchase stock in a company. In a cash account, they would be limited to the $10,000 they had deposited. However, by employing margin debt, they borrow the maximum amount allowable, $10,000, giving them a total of $20,000 to invest. They use nearly all of those funds to buy 1,332 shares of the company at $15 each.

After buying the stock, the price falls to $10 per share. The portfolio now has a market value of $13,320 ($10 per share x 1,332 shares). Even though the value of the stock fell, the investor is still expected to repay the $10,000 they borrowed through a margin loan.

Margin Trading Scenario 2

After purchasing 1,332 shares of stock at $15, the price rises to $20. The market value of the portfolio is $26,640. The investor sells the stock, pays back the $10,000 margin loan, and pockets $6,640 in profit (though this doesn’t account for interest payments on the margin loan). If the investor hadn’t used margin to increase their buying power, this transaction would have only earned a profit of $3,333.

Pros and Cons of Trading on Margin

Pros

• Can buy more than your cash account would allow
• Could realize higher returns by investing borrowed funds

Cons

• Could lose money
• Risk of rehypothecation

How to Get Margin on Your Account

Getting access to a margin account is fairly easy if you can meet minimum cash requirements. This requirement is known as the minimum margin. The Financial Industry Regulatory Authority (FINRA) has established a baseline minimum margin of $2,000.8 That means you have to deposit at least $2,000 to qualify for a margin account. Some brokerages may set their minimum margins higher.

Once you meet the minimum margin, all you have to do is fill out the form to apply for a margin account. You can open a new margin account or add margin trading capabilities to your current brokerage account. Either way, the application process will likely be similar.

Key Takeaways:- 

• Margin trading occurs when you borrow money from your brokerage to pay for stocks using your margin account assets as collateral.
• When you’re required to add cash or securities to your account it’s known as a margin call.
• If you can’t deposit the cash or stocks to cover the margin call, the brokerage can sell securities in your account.
• Margin trading offers the potential to make more money but comes with significant risks, including the possibility of losing more than you invested.