Trading on margin can magnify your returns, but it can also increase your losses. Learn the basics, benefits, and risks of margin trading.
Many investors are familiar with margin or margin trading but may be fuzzy on exactly what it is and how it works. That’s understandable, because margin rules differ across asset classes, brokerages, and exchanges.
For example, trading stocks on margin—under Regulation T, or “Reg T”—is quite different from trading futures on margin. But the underlying premise is the same: Margin is borrowed money, aka “leverage,” often aimed at magnifying gains (although margin will also magnify losses).
Here are a few basic questions and answers about margin trading.
You get more bang for your trading buck—or at least, that’s the idea. With margin trading, you’re only required to deposit a percentage of the notional value of a given security, which can juice your buying power. Margin provides “leverage” that, by taking on greater risk, could enhance returns. Through margin, you put up less than the full cost of a trade, potentially enabling you to take larger trades than you could with the actual funds in your account.
Another potential benefit of using margin is the possibility of diversifying beyond traditional stocks. Instead of limiting yourself to 100 shares of one stock, you can buy different stocks or ETFs, trade options (if approved), and access a line of credit.
Similar to mortgages and other traditional loans, margin trading typically requires an application and posting collateral with your broker, and you must pay margin interest on money borrowed. Margin interest rates vary among brokerages. In many cases, securities in your account can act as collateral for the margin loan. (A TD Ameritrade account that’s approved for margin trading must have at least $2,000 in cash equity or eligible securities and a minimum of 30% of its total value as equity at all times.)
Under Reg T, a Federal Reserve Board rule, you can borrow up to 50% of the purchase price of securities that can be purchased on margin, also known as “initial margin” (some brokerages require a deposit greater than 50% of the purchase price).
Exchanges and self-regulatory organizations, such as FINRA, have their own margin trading rules, 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 (SEC). FINRA requires a minimum deposit with a brokerage of $2,000, or 100% of the purchase price, whichever is less. This is known as the “minimum margin.”
Let’s say you want to buy 1,000 shares of a stock that’s currently trading at $50 per share. If you bought it with only the cash in your account, you’d need $50,000. But if you bought the shares through a margin account, you’d only need to have $25,000 in your account to purchase them—the other $25,000 would be covered by margin.
If the stock rises from $50 to $55 per share (for a gain of $5 per share, or $5,000), you’d have a 20% profit, because the gain is based on the $25 per share paid with cash and excludes the $25 per share paid with funds borrowed from the broker.
But margin cuts both ways. If the stock dropped to $45 per share, you’d have a loss of 20%—double what the loss would be if you paid for the stock entirely in cash.
Because margin magnifies both profits and losses, it’s possible to lose more than the initial amount used to purchase the stock. This magnifying effect can lead to a “margin call,” when losses exceed a limit set either by a broker or the broker’s regulating body. This “maintenance” margin limit may be increased by the broker without prior notice but often ranges from 30% to 40%, instead of the initial 50% required at the time of purchase.
The SEC spells out a pretty clear message. On their website it is stated that margin accounts “can be very risky and they are not suitable for everyone.” Before opening a margin account, the SEC suggested that investors “should fully understand that they can lose more money than they invested,” and they may be forced to sell some or all of their securities when falling stock prices reduce the value of their securities.
In volatile markets, the SEC explained that “investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls.” Some investors “have been shocked” to learn their brokerage has the right to sell their securities bought on margin—without any notification and potentially at a substantial loss to the investor, according to the SEC.
Qualified margin accounts can get up to twice the purchasing power of a cash account when buying a marginable stock, but with added risk of greater losses.
Learn the potential benefits and risks of margin trading.
Margin requirements—also called performance bonds—for futures trading are substantially lower than stocks, typically ranging from 3% to 15% of the total contract value. Performance bonds are financial guarantees required of both buyers and sellers of futures to ensure they fulfill contract obligations.
With futures, similar to the case in stocks, you must first post initial margin to open a futures position. If the margin equity falls below a certain amount, it must be topped up. This is known as the “maintenance margin” level.
Futures margins are set by the exchanges and vary depending on the commodity (market volatility is also a factor). For example, as of January 2020, CME Group WTI crude oil futures required a maintenance margin of about $3,700, or roughly 6% of the total contract value. (The contract was trading just under $60 per barrel in mid-January 2020, meaning one futures contract covering 1,000 barrels of oil had a notional value of about $60,000.)
Margin requirements in the retail foreign exchange (“forex”) market can be even lower—2% to 3% of the total value. “Generally, forex rules allow for the most leverage, followed by futures, then equities,” said Peter Klink, director of risk management at TD Ameritrade. “Depending on the product, forex and futures leverage can be at 20:1 or even 50:1 compared to equities’ overnight margin of 4:1.”
When used with caution and discipline, leverage can be a valuable tool in a trader’s arsenal, but the warning bears repeating: Margin is a double-edged sword. It can magnify losses as well as gains. If you plan to use margin, make sure you understand the risks and be sure to monitor your accounts carefully.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
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