Margin and Margin Trading Explained Plus Advantages and Disadvantages (2024)

What Is Margin?

Infinance,the marginis thecollateralthat an investor has to deposit with theirbrokeror exchange to cover thecredit riskthe holder poses for the broker or the exchange. An investor can create credit risk if they borrow cash from the broker to buy financial instruments, borrow financial instruments to sell themshort, or enter into aderivativecontract.

Buying onmarginoccurs when an investor buys an asset by borrowing the balance from a broker. Buying on margin refers to the initial payment made to the broker for the asset; the investor uses the marginable securities in their brokerage account ascollateral.

In a general business context, the margin is the difference between a product or service'sselling price and the cost of production, or the ratio of profit to revenue. Margincan also refer to the portion of the interest rate on an adjustable-rate mortgage(ARM) added to the adjustment-index rate.

Understanding Margin and Marging Trading

Margin refers to the amount of equity an investor has in their brokerage account."To buy on margin" means to use the moneyborrowed from a broker to purchase securities. You must have a margin account to do so, rather than a standard brokerage account. A margin account is a brokerage account in which the broker lends the investor money to buy more securities than what they could otherwise buy with the balance in their account.

Using margin to purchase securities is effectively like using the current cash or securities already in your account as collateral for a loan. The collateralized loan comes with a periodic interest rate that must be paid. The investor is using borrowed money, and therefore both the losses and gains will be magnified as a result. Margin investing can be advantageous in cases where the investor anticipates earning a higher rate of return on the investment than what they are paying in interest on the loan.

For example, if you have an initial margin requirement of 60% for your margin account, and you want to purchase $10,000 worth of securities, then your margin would be $6,000, and you could borrow the rest from the broker.

How the Process Works

Buying on margin is borrowing money from a broker in order to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally.

To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. With a margin account, you deposit cash, which serves as the collateral for a loan to purchase securities. You can use this to borrow up to 50% of the purchase price of an investment. So if you deposit $5,000, you could buy up to $10,000 in securities.

Your broker will charge interest on this loan you're using, which you'll need to repay. If you sell your securities, the proceeds will pay off your loan first, and you can keep what's left.

The Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) regulate margin trading, with strict rules as to how much you must deposit, how much you can borrow, and how much you must keep in your account.

Components of Margin Trading

Minimum Margin

By law, your broker is required to obtain your consent to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin.

Initial Margin

Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It's essential to know that you don't have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.

You can keep your loan as long as you want, provided you fulfill your obligations such as paying interest on time on the borrowed funds. When you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid.

Maintenance Margin and Margin Call

There is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a margin call.A margin call is effectively a demand from your brokerage for you toadd money to your accountor close out positions to bring your account back to the required level. If you do not meet the margin call, your brokerage firm can close out any open positions in order to bring the account back up to the minimum value. Your brokerage firm can do this without your approval and can choose which position(s) to liquidate.

In addition, your brokerage firm can charge you acommissionfor the transaction(s). You are responsible for any losses sustained during this process, and your brokerage firm may liquidate enough shares or contracts to exceed the initial margin requirement.

Special Considerations

Because using margin is a form of borrowing money it comes with costs, and marginable securities in the account are collateral. The primary cost is the interest you have to pay on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on. Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.

Not all stocks qualify to be bought on margin. The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers will not allow customers to purchase penny stocks or initial public offerings (IPOs) on margin because of the day-to-day risks involved with these types of stocks. Individual brokerages can also decide not to margin certain stocks, so check with them to see what restrictions exist on your margin account.

Advantages and Disadvantages of Margin Trading

Advantages

The primary reason investors margin trade is to capitalize on leverage. Margin trading centers increasing purchasing power by increasing the capital available to purchase securities. Instead of buying securities with money you own, investors can buy more securities using their capital as collateral for loans greater than their capital on hand.

For this reason, margin trading can amplify profits. Again, with more securities in hand, increases in value have greater consequential outcomes because you're more heavily invested using debt. On the same note, if the value of the securities posted as collateral also increase, you may be able to further utilize leverage as your collateral basis has increased.

Margin trading is also usually more flexible than other types of loans. There may not be a fixed repayment schedule, and your broker's maintenance margin requirements may be simple or automated. For most margin accounts, the loan is open until the securities are sold in which final payments are often due to the borrower.

Disadvantages

If investors primarily enter into margin trading to amplify gains, they must be aware that margin trading also amplifies losses. Should the value of securities bought on margin rapidly decline in value, an investor may owe not only their initial equity investment but also additional capital to lenders. Margin trading also comes at a cost; brokers often charge interest expense, and these fees are assessed regardless of how well (or poorly) your margin account is performing.

Because there are margin and equity requirements, investors may face a margin call. This is a requirement from the broker to deposit additional funds into their margin account due to the decrease in the equity value of securities being held. Investors must be mindful of needing this additional capital on hand to satisfy the margin call.

Should investors not be able to contribute additional equity or if the value of an account drops so fast it breaches certain margin requirements, a forced liquidation may occur. This forced liquidation will sell the securities purchased on margin and may result in losses to satisfy the broker's requirement.

Example of Margin

Let's say that you deposit $10,000 in your margin account. Because you put up 50% of the purchase price, this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and haven't tapped into your margin. You start borrowing the money only when you buy securities worth more than $10,000.

Note that the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account.

Other Uses of Margin

Accounting Margin

In business accounting, margin refers to the difference between revenue and expenses, where businesses typically track their gross profit margins, operating margins, and net profit margins. The gross profit margin measures the relationship between a company's revenues and the cost of goods sold (COGS). Operating profit margin takes into account COGS and operating expenses and compares them with revenue, and net profit margin takes all these expenses, taxes, and interest into account.

Margin in Mortgage Lending

Adjustable-rate mortgages (ARM) offer a fixed interest rate for an introductory period of time, and then the rate adjusts. To determine the new rate, the bank adds a margin to an established index. In most cases, the margin stays the same throughout the life of the loan, but the index rate changes. To understand this more clearly, imagine a mortgage with an adjustable rate that has a margin of 4% and is indexed to the Treasury Index. If the Treasury Index is 6%, the interest rate on the mortgage is the 6% index rate plus the 4% margin, or 10%.

The Bottom Line

Investors looking to amplify gain and loss potential on trades may consider trading on margin. Margin trading is the practice of borrowing money, depositing cash to serve as collateral, and entering into trades using borrowed funds. Through the use of debt and leverage, margin may result in higher profits than what could have been invested should the investor have only used their personal money. On the other hand, should security values decline, an investor may be faced owing more money than what they offered as collateral.