Margin Trading explained

What Is Margin?

In finance, margin refers to the collateral that an investor must deposit with their broker or exchange to mitigate the credit risk they pose. This risk arises when an investor borrows funds from the broker to purchase financial instruments, borrows securities to sell them short, or enters into derivative contracts.

Buying on margin involves an investor purchasing an asset using borrowed funds from a broker. This practice entails making an initial payment to the broker for the asset, with the marginable securities in the investor's brokerage account serving as collateral.

In a broader business context, margin represents the difference between the selling price of a product or service and its production cost, or the ratio of profit to revenue. Additionally, margin can denote the portion of the interest rate on an adjustable-rate mortgage (ARM) that is added to the adjustment-index rate.

Understanding Margin and Margin Trading

Margin refers to the equity an investor holds in their brokerage account. "Buying on margin" means purchasing securities using funds borrowed from a broker. This requires a margin account, which is different from a standard brokerage account. In a margin account, the broker lends the investor money to buy more securities than they could with just the cash balance in their account.

When using margin to purchase securities, the investor essentially uses the cash or securities already in their account as collateral for a loan. This loan comes with an interest rate that must be paid periodically. Because the investor is using borrowed money, both potential losses and gains are amplified. Margin investing can be beneficial when the investor expects to earn a higher return on the investment than the interest paid on the loan.

For instance, if your margin account has an initial margin requirement of 60%, and you want to buy $10,000 worth of securities, your margin would be $6,000, allowing you to borrow the remaining $4,000 from the broker.

However, the Securities and Exchange Commission has cautioned that margin accounts can be very risky and may not be suitable for all investors.

How the Process Works

Margin buying involves borrowing funds from a broker to purchase stocks, similar to taking a loan from your brokerage. This method enables you to buy more stocks than you could with just your own money.

To engage in margin trading, you need a margin account, distinct from a regular cash account where you trade using available funds. In a margin account, your cash deposit acts as collateral for a loan to buy securities. You can borrow up to 50% of an investment's purchase price, so with a $5,000 deposit, you could acquire up to $10,000 in securities.

Your broker will charge interest on this borrowed amount, which you must repay. When you sell your securities, the sale proceeds will first pay off your loan, and you retain any remaining balance.

The Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) oversee margin trading, enforcing strict regulations on the amounts you must deposit, borrow, and maintain in your account.

Components of Margin Trading

Minimum Margin

Legally, brokers must get your consent to open a margin account, which can be included in your standard account agreement or might be a separate document. To open a margin account, you must make an initial investment of at least $2,000, though some brokers may set a higher requirement. This initial deposit is referred to as the minimum margin.

Initial Margin

After opening your margin account, you can borrow up to 50% of the purchase price of a stock. The amount you contribute toward the purchase price is called the initial margin. It's important to note that you don't have to borrow the full 50%; you can choose to borrow a smaller percentage, such as 10% or 25%. Some brokerages may also require a deposit greater than 50% of the purchase price.

You can maintain your loan for as long as you meet your obligations, such as paying interest on time. When you sell stock in a margin account, the proceeds are first used to repay the loan to your broker until it is fully settled.

Maintenance Margin and Margin Call

Another important aspect of margin trading is the maintenance margin, which is the minimum account balance you must maintain to avoid your broker requiring additional funds or selling stock to reduce your loan. This requirement, known as a margin call, occurs when your account balance falls below the maintenance margin level. A margin call is a demand from your broker to deposit more money into your account or to close positions to restore your account to the required level. If you fail to meet the margin call, your brokerage firm can sell any of your open positions to bring the account back up to the minimum value without needing your approval and can choose which positions to liquidate.

Additionally, your brokerage firm may charge you a commission for these transactions. You are liable for any losses incurred during this process, and your brokerage firm might liquidate enough shares or contracts to exceed the initial margin requirement.

Special Considerations

Using margin involves borrowing money, which incurs costs, and the marginable securities in your account serve as collateral. The primary cost is the interest you must pay on the loan, which accrues over time if not paid. This increases your debt level and the associated interest charges, creating a compounding effect. Therefore, margin trading is typically used for short-term investments, as holding investments long-term on margin requires higher returns to break even. The longer you hold the investment, the lower the chances of making a profit due to accumulating interest.

Not all stocks are eligible for margin trading. The Federal Reserve Board regulates which stocks can be bought on margin. Generally, brokers do not allow the purchase of penny stocks or initial public offerings (IPOs) on margin due to their high risk. Additionally, individual brokerages may have their own restrictions on certain stocks, so it's important to check with your broker to understand the limitations of your margin account.

Advantages and Disadvantages of Margin Trading

Advantages

• Potential for Greater Gains: Leverage can amplify your investment returns.
• Increased Purchasing Power: Allows you to buy more securities than you could with your own funds.
• Flexibility: Often more flexible compared to other types of loans.
• Opportunity Cycle: Rising collateral values can further increase leverage opportunities.

Disadvantages

• Potential for Greater Losses: Leverage can also amplify your losses.
• Additional Costs: Incurs fees and interest charges.
• Margin Calls: May require additional equity investments to meet margin calls.
• Forced Liquidations: Can result in the sale of securities, often at a loss, if margin calls are not met.

Advantages

The main advantage of margin trading is the ability to leverage investments. By increasing the capital available to purchase securities, margin trading enhances purchasing power. Investors use their existing capital as collateral to borrow funds and buy more securities than they could with their own money alone.

This leverage can significantly amplify profits, as holding more securities means that any increase in their value results in greater overall gains. Additionally, if the value of the securities used as collateral increases, it may allow for further leverage opportunities as the collateral value grows.

Margin trading also tends to be more flexible than other types of loans. There often isn't a fixed repayment schedule, and the maintenance margin requirements set by brokers can be straightforward or automated. Typically, the loan remains open until the securities are sold, at which point the final repayment is made.

Disadvantages

While investors engage in margin trading to amplify gains, they must be aware that it also amplifies losses. If the value of securities bought on margin declines significantly, an investor might owe more than their initial equity investment, requiring additional capital to repay lenders. Margin trading incurs costs, including interest expenses charged by brokers, regardless of the account's performance.

Due to margin and equity requirements, investors may face a margin call, where the broker demands additional funds to be deposited into the margin account because of a drop in the equity value of the securities held. Investors need to have extra capital available to meet these margin calls.

If investors cannot provide additional equity, or if the account value drops rapidly and breaches certain margin requirements, a forced liquidation may occur. This means the broker will sell the securities bought on margin, potentially resulting in losses to meet the broker's requirements.

Example of Margin

Suppose you deposit $10,000 into your margin account. With a 50% margin requirement, this gives you $20,000 in buying power. If you purchase $5,000 worth of stock, you still have $15,000 in remaining buying power. At this point, you haven't used your margin since your cash covers the transaction. You only start borrowing funds when you buy securities exceeding $10,000.

It's important to note that the buying power of a margin account fluctuates daily based on the price movements of the marginable securities in the account.

Other Uses of Margin

Accounting Margin

In business accounting, margin represents the difference between revenue and expenses. Companies commonly monitor various margins such as gross profit margin, operating margin, and net profit margin. The gross profit margin assesses the relationship between a company's revenue and its cost of goods sold (COGS). The operating profit margin includes both COGS and operating expenses, comparing them to revenue. The net profit margin accounts for all expenses, including taxes and interest, in relation to revenue.

Margin in Mortgage Lending

Adjustable-rate mortgages (ARMs) have a fixed interest rate for an initial period, after which the rate adjusts. The new rate is determined by adding a margin to an established index. Typically, the margin remains constant over the life of the loan, while the index rate fluctuates. For example, consider a mortgage with a 4% margin indexed to the Treasury Index. If the Treasury Index is at 6%, the interest rate on the mortgage would be the sum of the 6% index rate and the 4% margin, resulting in a 10% interest rate.

What Does It Mean to Trade on Margin?

Trading on margin involves borrowing money from a brokerage firm to execute trades. Investors deposit cash as collateral for the loan and pay ongoing interest on the borrowed amount. This loan enhances the investor's buying power, enabling the purchase of more securities. The purchased securities automatically serve as collateral for the margin loan.

What Is a Margin Call?

A margin call occurs when a broker who extended a margin loan to an investor requires them to increase the collateral in their margin account. To meet a margin call, investors typically need to deposit additional cash or sell other securities. If the investor fails to comply, the broker can forcefully sell the investor's positions to raise the required funds. Margin calls are often dreaded by investors as they may necessitate selling positions at unfavorable prices.

What Are Some Other Meanings of the Term Margin?

Beyond margin lending, the term margin has several other uses in finance. It can refer to various profit margins, such as gross profit margin, pre-tax profit margin, and net profit margin. Additionally, margin can sometimes denote interest rates or risk premiums.

What Are the Risks of Trading on Margin?

Trading on margin carries the risk of losing more money than the initial deposit in the margin account. This risk arises when the value of the held securities declines, potentially requiring the investor to provide additional funds or face a forced sale of the securities.

The Bottom Line

Investors aiming to amplify potential gains and losses might consider margin trading. This practice involves borrowing money, using deposited cash as collateral, and making trades with the borrowed funds. By leveraging debt, margin trading can lead to higher profits than using only personal funds. However, if the value of the securities decreases, the investor could end up owing more than the initial collateral.