The Double-Edged Sword of Margin: Know the Right Way & the Wrong Way

Trading with margin is like many parts of an investing strategy: There are “enlightened” ways to use margin and “unenlightened” ways. Apply margin prudently and thoughtfully, and you can amplify returns and add diversification and flexibility to your portfolio. Do margin the wrong way? You could lose your shirt.

Enlightened margin trading “is all about awareness,” said Chris Jennings, director of margin product at TD Ameritrade. Added Mark Woodward, senior manager, margin product at TD Ameritrade: “Not everyone is aware of the potential benefits. Trading with margin is relatively straightforward and can be beneficial to some investors in many ways.”

“Yet, you can’t ignore the risks of trading with margin,” Jennings said. “Margin borrowing involves leverage, which amplifies both gains and losses.”

Here are a few margin basics. And if you have immediate questions, TD Ameritrade has licensed representatives available at all times at (800) 669-3900 to help walk clients through the potential benefits and risks of margin.

What Is Margin Trading?

Margin is borrowed money used to buy stocks or other securities. In margin trading, a brokerage firm lends an account owner a portion (typically 30% to 50%) of the total purchase price, raising the investor’s buying power by a commensurate amount. Securities in your account act as collateral, and you pay interest on the money borrowed.

Trading stocks on margin is typically regulated by the Federal Reserve’s Regulation T (aka, Reg T), under which you can currently 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. Exchanges and brokerages can establish their own margin requirements, if they’re at least as restrictive as Reg T.

Is Margin Common in U.S. Markets?

Historically, margin trading tends to increase during bull markets, and some statistics suggest margin trading has risen in 2019 as the U.S. stock market scaled record highs.

At the end of June 2019, debit balances in U.S. securities margin accounts (aka, margin debt) totaled $596.3 billion, according to the Financial Industry Regulatory Authority (FINRA), a nongovernment organization that oversees U.S. brokers. The June number was up 7.6% from $554.3 billion at the end of 2018 but down 7.8% from $646.9 billion in the same month a year earlier.

Based on FINRA data, margin trading has jumped sharply this decade. At the end of June 2010, margin debt totaled $263.2 billion, less than half the current level.

Potential Benefits of Using Margin

Jennings pointed out that qualified investors can use margin to diversify beyond traditional stocks, apply margin to buy and hold strategies, and expand into options-based strategies. With margin, “you can access more funds across the board,” he said. “In the case of diversification, instead of buying just 100 shares of a stock, you could buy a few different stocks or ETFs. You can also sell stocks short and potentially pocket gains if stock prices decline.” Of course, shorting stocks is subject to unlimited loss potential since there's no limit to how high the price of a stock can climb.

Margin can be abused, and it has taken some blame for contributing to historical market turmoil (the October 1929 crash, for example). So, “there’s a little bit of stigma surrounding margin,” Jennings pointed out.

How Margin Trading Works

Say for example you want 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. Using margin in this example, you can borrow the additional $10,000 to purchase those 1,000 shares.

If the stock rises from $20 to $25 per share (a gain of $5 per share, or $5,000 total), you’d have a 50% profit, based on the $10 per share bought with cash and excluding the $10 per share bought with borrowed funds.

However, if the share price dropped to $15, 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.

Applying Margin in Different Market Conditions

If margin is used properly, it can offer opportunities in many different market circumstances, including a recession market and a highly volatile market.

“With the extra buying power of margin, you can be more flexible in any sort of market situation,” Jennings pointed out.

Approval Process for Trading with Margin

At TD Ameritrade, for example, investor and trader clients with at least $2,000 of equity in an account can apply for margin privileges.

Once an account has been approved for borrowing, the account owner can take out a loan without filling out other forms or paying additional fees. The approval process can be relatively fast—within the next business day (see sidebar.)

Margin as a Short-Term Source of Credit

Stock in your account can serve as collateral for a margin loan that could be used for short term financing. For example, if you have a $100K stock portfolio you could pull out $30K from your margin account to fund a variety of liquidity needs.

“Margin interest rates can be competitive and in some cases lower than other loan products.” Jennings pointed out. “As long as you stay above your equity threshold, you can use a margin account for many purposes.”  Woodward added, “With margin, you gain instantaneous access to funds with no extra hassle of paperwork, and there’s no set repayment period like with credit cards.”

Common Mistakes Involving Margin (i.e., Margin Pitfalls)

One big mistake with margin is placing a trade or position “fully extended,” as Jennings put it. In other words, if you have $100,000 of available margin, it’s inadvisable to go all the way to that limit. Jennings and Woodward both cautioned against such “overleveraging.”

“It can be helpful to leave additional buying power left over as a reserve in case markets move against you, said Jennings. “That has two potential benefits—it reduces the likelihood of a margin call, and the remaining buying power can be deployed to buy additional stock if prices decline, potentially lowering your cost basis.”

“If you’ve leveraged yourself too far, even if it’s just one position, and that position goes the wrong way, it could put you into a margin call and end up being very costly,” Woodward added. 

Margin Call Overview

Because margin magnifies both profits and losses, it’s possible to lose more than the initial amount used to purchase assets. This magnifying effect can lead to a margin call—when losses exceed a limit set by either a broker or the broker’s regulating body. If this happens, you’ll hear from your broker.

The broker may try to give you some time to meet the margin call but can close your positions without notice. The broker may raise the “maintenance” margin limit without notice, but the limit often ranges from 30% to 40%, instead of the initial 50% required at the time of purchase.

Bottom Line

When used appropriately, margin can help traders and investors pursue their investing objectives. But it’s important to fully understand the risks. If you want to find out more, to see if margin might be right for you, visit the TD Ameritrade Margin Trading page or watch the video below.

Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details. Please see our website or contact TD Ameritrade at 800-669-3900 for copies.