Beyond Margin Basics: Ways Investors & Traders May Apply Margin

Investing or trading on margin at its most elementary level is akin to wrapping your hands around one of humankind’s oldest, most powerful tools: the lever. With margin, investors can borrow money to “lever up” their portfolios, gaining additional “muscle” to juice returns or diversify a portfolio. Margin can cut the opposite way, too, by amplifying losses.

Margin is borrowed money that’s used to buy stocks or other securities. In margin trading, a brokerage firm lends an account holder a portion (typically 30% to 50%) of the total purchase price, meaning an investor’s buying power goes up a commensurate amount. Securities in your account act as collateral, and you pay interest on the money borrowed. And since cash and securities in a margin account can act as collateral, some choose to use a margin account as a line of credit, designed to have a flexible repayment plan. 

In other words, once you move beyond the basics of margin, you'll see how it can be applied a variety of ways, depending on the type of investor or trader you are. Here are five broad categories of investor and trader types and how they might use margin.

Margin for Individual Stocks Over a Longish Term

Trading stocks on margin is typically governed by Regulation T (aka, Reg T), under which you can borrow up to 50% of the purchase price of securities. This is also known as “initial margin,” as some brokerages require a deposit greater than 50% of the purchase price. However, exchanges and brokerages can establish their own margin requirements as long as they are at least as restrictive as Reg T, according to the U.S. Securities and Exchange Commission.

For example, suppose you’d like to buy 1,000 shares of a stock currently trading at $20, or $20,000 worth, but you have only $10,000 available to invest. With margin, you can borrow an additional $10,000 and purchase those 1,000 shares.

If the stock rises from $20 to $25 a share (a gain of $5 per share, or $5,000), you’d have a 50% profit, because the gain is based on the $10 a share paid with cash, and excludes the $10 a share paid with funds borrowed from the broker. However, if the stock dropped to $15 a share, you’d have a loss of 50%—double what the loss would be if you paid for the stock entirely in cash. Also, you’ll likely be subject to a margin call, which means you must provide additional funds in order to maintain the required minimum.

But margin isn’t limited to the long side. Investors with margin privileges can sell stocks short as well, with the aim of making money during, or hedging against, a market decline. 

Margin for the “Active” Trader

For traders and investors who buy and sell frequently, margin can be a handy ally when near-term potential opportunities pop up.

Individual investors and traders can apply for a regular margin account with as little as $2,000 but there are rules regarding what's called a pattern day trader, which is defined by FINRA as a margin account that executes four or more day trades or round trips within a rolling 5-business day period. Basically such accounts can only open and close a position within the same day 3 times within that time frame, or else the account will be flagged, and will then need a minimum equity balance of $25,000 or more. 

In other words, if you have $25,000 in your account above and beyond any money needed to hold securities, if approved for margin, you have access to $100,000 of day-trading buying power. Still, keep in mind that if your equity drops below the $25,000 minimum for pattern day trading, you may be subject to a minimum day-trading equity call. Figure 1 shows how you can assess the impact of an individual trade before you make it.

Margin for Stock Options Traders

Like the options market itself, trading on margin in options is a quite different, and often more complicated and risky, ball game.

For “defined-risk” options strategies—such as long puts and calls, verticals, and iron condors—margin requirements are relatively straightforward. Margin functions like a cash account inside your “margin” account, meaning you simply need to put the cash up for the cost of long trades. Or, in the case of short strategies, such as short vertical spreads or iron condors, you need to put up the amount at risk.

Short vertical spreads, for example, would require the difference between the strike prices less the premium received on the sell side of the vertical. Remember, if or when you exercise such strategies, you need to follow the margin rules on the stock or underlying.

For option traders willing to step further out on the tightrope, there’s selling calls or puts “naked,” meaning with no hedging position in place to offset any losses.*

Margin for the Futures (or Options on Futures) Trader

Much like margin trading in stocks,futures margin—also known unofficially as a performance bond—allows you to pay less than full price of a trade, enabling larger positions than could otherwise be made with your actual funds.

In futures markets, an investor or trader puts down a good-faith deposit with a broker called the initial margin requirement that ensures each party (buyer and seller) can meet their obligations as spelled out in the futures contract. Initial futures margin requirements vary by commodity and market volatility and are typically a small percentage—2% to 12%—of the notional value of the contract.

Margin for the Long-Term Investor Seeking Short-Term Financing

Much like other traditional loans, margin requires the posting of collateral to backstop the money you’re borrowing. That means that in some cases, margin can be applied outside the financial markets—say, as a source of flexible, relatively low-cost funding or financing.

However, it’s important to be cognizant of unique risks if margin is used for such purposes, as well as any tax implications. For example, interest expense would typically only be tax deductible if you use the proceeds of the debt to purchase investments, and those investments generate taxable net investment income. Another risk when using margin as financing is that your collateral—the securities in your account—could depreciate in value and trigger a margin call (see above). At that point you would be required to to deposit funds to meet the margin call. So in essence, a margin loan could be called in at any time. 

Bottom Line

Whichever investor or trader profile fits you, it’s important to remember that margin can be a useful tool if applied with prudent risk-management techniques. But it’s not to be abused or trifled with. Margin offers a number of potential benefits, but it comes with unique risks.