Many investors may have heard of “margin trading” or “trading on margin,” but may not be sure what it really means to use margin when trading.
Margin trading is an investing strategy that involves borrowing money to invest. This can increase an investor’s potential returns. However, margin trading is risky because it also increases potential losses.
What Is Margin Trading?
Trading on margin means borrowing money from someone, typically a brokerage company, to invest in securities.
For example, someone who wants to invest in SPY — an exchange-traded fund (ETF) that tracks the S&P 500 — could use their own money to buy shares. They could also use some of their own money and some borrowed money (margin) to buy those shares.
By borrowing money to buy shares, an investor can increase the number of shares they’re able to purchase. If the shares increase in value, the investor will make more money because they hold more shares than they could afford with their own money alone. If the shares lose value, the investor will lose more money.
Who Offers Margin Trading?
Margin trading is a service offered by brokerage companies like E*Trade. If you’re interested in trading on margin, you should examine a few different brokerage companies to see if they offer margin trading.
Each brokerage will have different requirements to qualify for margin trading and different terms for its services.
For example, one broker may only require that you have a balance of $2,000 — the legal minimum requirement — before you can trade on margin, while another broker might require you to deposit at least $10,000 before offering margin trading.
Each broker can also set different margin requirements — how much of your own money you must have in the account compared to borrowed money — and interest rates.
Depending on your financial situation and investing strategy, different brokers’ margin trading services can be a better or worse fit for you.
How Does Margin Trading Work?
The first step in margin trading is signing a margin trading agreement and opening a margin trading account. Some brokers don’t require a separate account, instead adding margin privileges to an investor’s standard brokerage account.
The next step is funding the account. Federal regulations require that you have at least $2,000 in your account before you can trade on margin.
However, brokerage companies can set any requirement that they would like, so long as it isn’t lower than the $2,000 minimum. A brokerage might make you deposit $5,000, $10,000, or more before allowing you to trade on margin.
Once the account is funded, you can start buying stocks using margin, up to your margin limit. The margin limit is the amount you’ve borrowed divided by the total value of your portfolio. The maximum margin limit a brokerage can allow is 50%, but brokerages are free to have lower margin requirements.
For example, if you have $10,000 of your own money in a margin trading account, you could buy up to $20,000 worth of a stock. If you do so, your account will be worth $20,000 and you will have $10,000 in debt.
$10,000 divided by $20,000 is 50%, so you will have maxed out your margin.
If the shares fall in value, you will have less than $20,000 in the account but still have $10,000 in debt, putting your margin use over 50%. If this happens, you’ll have to add more funds to the account to return to a 50% margin level or sell some shares to pay off some of your debt.
If the shares gain value, your portfolio will be worth more than $20,000 but you will still have $10,000 in debt. This reduces your margin utilization, giving you the opportunity to borrow more money on margin.
Benefits of Margin Trading
There are a few benefits to trading on margin.
1. Increased Buying Power
The most obvious benefit of margin trading is that it increases an investor’s buying power. If your brokerage lets you use the largest amount of margin allowed by law, it effectively doubles your buying power.
For example, an investor with $50,000 could buy as much as $100,000 worth of securities by using margin. This lets investors make much larger purchases than they have the capital to make.
2. Higher Potential Returns
Increased buying power gives you the chance to buy more securities than you could otherwise afford. The more securities you own, the greater your potential profit if those securities gain value.
If you buy 100 shares in a company at $50 each, you’ll have spent $5,000 on the shares. If those shares increase in value by 5%, you will make $250 if you sell those shares.
By trading on margin, you could buy as many as 200 shares instead of just 100. If those shares experience the same 5% gain, your gains will be $500 instead of $250.
This increases your percentage return as well. You made $500 on an initial investment of $5,000, meaning the gain on the money you invested was 10% when the share price rose by 5%.
Margin gives investors more buying power, which means they can purchase more different securities, such as stocks and bonds, in their portfolios.
Margin can increase the amount of money you can use to buy stocks and bonds, making it easier to spread your investments out and buy a variety of securities, diversifying your portfolio.
Pro tip: If you’re going to add new investments to your portfolio, make sure you choose the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Drawbacks of Margin Trading
There are downsides to margin, and it’s important to understand them before deciding to use margin.
1. Higher Risk
Borrowing money for almost any purpose is risky. You have to pay back the loan eventually.
Borrowing money to invest is doubly risky. There’s no guarantee that an investment will succeed. Whether the securities you buy gain or lose value, you will have to pay back the amount that you borrowed.
If you use margin to buy stocks that fall in price, you will lose more money than you would have lost if you didn’t use margin. In some cases, you could wind up losing more money than was put into your portfolio.
For example, say you buy stock worth $20,000. You use $10,000 of your own money to pay for the purchase and $10,000 of margin. If the shares lose 75% of their value, you’ll only be able to get $5,000 if you sell the shares.
You will have to use that $5,000 to repay some of the margin loan and will need to come up with the remaining $5,000 to pay the debt some other way.
Borrowing money isn’t free. Almost every loan means paying interest, and margin is no different. When you use margin to invest, you have to pay interest based on the amount of money that you’re borrowing.
Each brokerage can set its margin interest rates. Some charge the same rates regardless of how much you borrow while others adjust the rate as you borrow more — often lowering the rate the more you borrow.
Investors need to account for the cost of borrowing money to invest on margin before borrowing money. The interest charges reduce gains on successful investments and increase losses from poor-performing investments.
Even if the shares you buy maintain their value, the cost of borrowing money can lead to you losing money.
3. Maintenance Requirements
Brokerages that offer margin typically have two margin requirements: one for opening a new position and one for maintaining an existing position.
For example, a brokerage may let you open a new position with 50% margin. Effectively, you can borrow up to the amount of money you’ve put into your portfolio so that half of the purchase comes from your own funds and half is borrowed from the brokerage.
Once you open a position by buying shares, the portfolio has to maintain enough value to meet the brokerage’s maintenance margin requirement.
For example, a broker may have a 25% maintenance margin requirement — that means an investor has to have equity in their account equal to 25% of the account’s value at any given time.
Put another way, the investor’s margin debt can’t exceed 75% of the account’s value.
To calculate this, divide the value of the portfolio by the amount of money the investor borrowed. For example, if you buy $10,000 of stock using $5,000 of your own money and $5,000 of borrowed funds, you’re using 50% margin.
- If the shares gain value and the account balance rises to $15,000, you will be using 33.33% margin ($5,000 borrowed divided by the $15,000 account balance), which means you have 66.67% equity.
- If the shares lose value, dropping to a total value of $5,000, your margin will be 100% ($5,000 borrowed divided by the $5,000 account balance), which means you have 0% equity.
If an investor’s portfolio fails to meet the maintenance margin requirement, it can trigger a margin call, which forces the investor to deposit more funds or sell their investments.
Brokerages can change their margin requirements if they feel the need to, for example during uncertain economic times. If an investor is on the cusp of falling below margin requirements, this can pose an issue and trigger a margin call. This uncertainty can be difficult for investors to handle.
What Is a Margin Call?
If your account value falls below the brokerage’s maintenance margin requirement, the brokerage will initiate a margin call.
When a brokerage makes a margin call, it informs you that your account value has dropped below the maintenance requirement. You then have a limited amount of time to deposit additional money to your account to bring the balance above the margin requirement.
For example, if you have an account holding $5,000 worth of shares and a margin loan of $5,000, your account margin is 100%. To bring it below the 75% requirement, you must deposit additional funds to bring your account balance above $6,666.67. That means coming up with another $1,666.67 to add to the account.
If you fail to deposit enough money to satisfy the margin call, the brokerage will sell some of your shares to pay back the margin debt until the account returns to compliance with the margin requirements. The brokerage can sell the shares without your permission to do this.
On top of this, you remain responsible for the money you borrowed. If the shares the brokerage sells don’t cover the full amount of your debt, you must deposit more money to the account or sell other shares to repay what you borrowed.
Is Trading on Margin a Good Idea?
Trading on margin can be tempting for many investors because it lets them buy more shares than they can afford using their own money. If they make a successful investment, margin trading can increase their gains.
However, using margin is also highly risky. Just as it increases gains, it increases losses. Investors using margin can wind up losing more than they initially invested. They also have to pay interest on the money they borrow, adding to their investment costs.
For most investors, trading on margin is a bad idea because of the high risks involved. When investing normally, the worst-case scenario is losing the money you invest.
Using instruments like derivatives and margin can result in losing more than the initial investment, which can lead unprepared investors into debt or having to sell other assets to cover their costs.
Investing on margin can be tempting for active investors who want to boost their buying power, but its risks mean that it’s rarely worth it for most investors.
Other ways investors can leverage their portfolios include using derivatives like options. People who prefer a hands-off approach to investing will likely want to avoid margin and stick with investing in things like mutual funds and ETFs.
Ultimately, margin investing is best for highly experienced investors who are looking to execute a complex trading strategy and who need access to extra capital to do so.
Less experienced investors should avoid margin, although using an incredibly small amount that you can easily afford to repay can limit the risks of using it.