Margin trading means buying stocks with borrowed funds - it's riskier than paying cash, but the returns can be greater
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- Margin trading is the practice of borrowing money from your broker to buy stocks, bonds, or other securities.
- Margin trading allows you to invest more than you normally would, or to diversify among a greater number of investments.
- Margin trading amplifies investment profits but also losses, making the strategy more risky and volatile than investing with cash.
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Borrowing money increases buying power - that's how you purchase a house or other big-ticket items you can't afford outright. But did you know that you can do that with stocks, too?
It turns out that many investors can. Depending on your brokerage account type and balance, you may have the ability to do margin trading - or leverage your capital, as the pros call it.
But even if you are able to, is it a good idea to use borrowed money to invest in stocks? And do the advantages outweigh the risks? Here's what you should know before testing the waters with margin trading.
What is margin trading and how does it work?
Margin trading, aka buying on margin, is the practice of borrowing money from your stock broker to buy stocks, bonds, ETFs, or other market securities. When you buy any of these investments on margin, the investment itself is used as collateral for the loan. By trading on margin, investors can increase their buying power by up to 100%.
Here's how it works: Let's say that you decide to buy $10,000 worth of XYZ stock. You pay $5,000 in cash and borrow - buy on margin - the other $5,000. Now imagine that your investment grows by 25% to $12,500. In this example, your actual return on investment would be 50%, since your cash outlay was only $5,000.
The example above may sound pretty great. But keep in mind that margin trading amplifies losses just as it does for profits. If your $10,000 investment decreased by 25% to $7,500, you'd effectively lose 50% on the trade.
It's also important to keep in mind that brokers don't lend margin funds for free. Like other loans, margin loans are charged interest. Margin rates are generally lower than the annual percentage rates (APR) of personal loans and credit cards, though, and there is typically no set repayment timetable.
Since margin positions are often held for relatively short periods of time, interest charges are typically reasonable. However, the longer your margin loan remains unpaid, the more you'll want to consider how interest costs could impact your returns.
Advantages of margin trading
While it may seem that margin trading means bigger profits, that's not technically true. If a $50,000 stock investment grows by 10%, your profit will be $5,000 regardless of whether you bought that stock with cash only or a combination of cash and margin.
In fact, you'll have slightly less money at the end than if you had bought the stock outright since you'll have to pay interest on the borrowed amount.
But margin trading does allow for a better percentage return. It also:
- Increases your buying power: Margin trading enables you to invest more than you otherwise could. For stocks with very high share prices, using margin may be the only way to invest in them at all.
- Enhances your ability to diversify: Using just cash, you might be able to invest in two or three stocks; by borrowing, you may be able to buy several more stocks (or bigger stakes in each stock) to spread out your risk. In fact, this technique, called leveraging, is the primary way day traders and professional money managers use margin - to take a lot of different positions and increase their chances of hitting a winner.
Dangers of margin trading
Using leverage to increase investment size, as margin trading does, is a two-edged sword. On one hand, it can significantly increase your rate of return. But losses can also multiply fast. For example, a 50% decrease in a stock's value could wipe out your account's cash balance entirely - because you're still on the hook to repay the amount you originally borrowed.
There's another risk: A decline in your investments can lead to an account falling below the broker's maintenance margin (the minimum balance, in either cash or securities, that you're required to keep in the account). When this happens, the broker will issue a margin call.
What is a margin call?
A margin call is your broker basically demanding or "calling in" part of your loan. A margin call requires more funds to be added to your account to bring its balance back above the minimum requirements.
If you can't promptly meet the margin call, your broker has the right to sell some of your securities to bring your account back up to the margin minimum. What's more, your broker does not need your consent to sell your securities. In fact, they may not be required even to make a margin call beforehand.
The potential for a margin call and the involuntary sale of assets makes trading on margin riskier than other forms of financing.
With a mortgage, for instance, your lender can't foreclose on your home just because its appraised value has gone down. As long as you continue to make your mortgage payments, you get to keep your home and can wait to sell until the real estate market rebounds.
But with margin trading, you can't always just wait out dips in the stock market. If the stock price falls and your equity dips below the minimum margin trading requirement, you'll need to add more capital or risk having some of your securities sold at a serious loss.
Your equity percentage, or ownership stake in the company, is calculated by dividing the current value of your securities by your debt. Let's say you bought $12,000 of securities with $6,000 of cash and $6,000 of margin. In this case, your starting equity percentage would be 50% ($6,000/$12,000 = 0.50).
If the value of the securities dropped to $8,000, your equity would fall to $2,000 ($8,000- $6,000 = $2,000). This would bring your equity percentage down to 25% ($2,000/$8,000 = 0.25). If your broker's maintenance requirement was 30% equity, this drop would trigger a margin call.
How to buy on margin
According to the rules set by the Financial Industry Regulatory Authority (FINRA), you'll need to have at least $2,000 to apply for a margin account. But brokerages are free to set higher minimums. If you meet your broker's initial margin requirements, you'll probably have the option to apply for margin approval online.
During the application process, you'll be required to sign a "Margin Agreement," which outlines all the broker's rules and requirements. Be sure to carefully read through the agreement before signing, paying special attention to how interest accumulates and is repaid.
In addition to the minimum cash value needed to open a margin account, there are two more margin requirements to note:
- Initial margin: FINRA allows investors to borrow up to 50% of the security's price. Some brokers set the limit even lower, requiring bigger cash down payments.
- Maintenance margin: FINRA requires investors to keep an equity percentage of at least 25% in a margin account. Many brokers set higher maintenance margins.
In other words, you can't use margin to finance more than half a stock purchase and must maintain cash reserves at all times. These limits are largely for your own protection.
Not all securities can be bought on margin. Mutual funds are not available for margin trading, since their prices are set just once a day.
You can't fully trade on margin inside an IRA as these are considered cash accounts. Some brokers, however, will allow clients to apply for "limited margin," which allows them to buy securities with unsettled cash.
The financial takeaway
Margin trading involves significantly higher risk than investing with cash. If the trade goes badly against you, you could even end up losing even more than you initially invested outright. And even if the trade goes your way, interest charges on the money you borrow can eat into your profits.
But provided that you fully understand the risks and costs, margin trading could increase your profits and return on your investments. It can allow you to invest in a greater range of securities, too.
If you do decide to trade on margin, start small. Limiting your loan amounts to well below your overall margin-account value, and margin limits, can reduce your risk.
Also, contain your margin trades to short periods of time. That'll limit your exposure to market volatility and minimize your interest charges. And keep your eye on the markets, being ready to move fast. Margin trading rewards the nimble-minded - it's definitely not a passive, set-it-and-forget-it investing strategy.