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.
Bruce Blythe is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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.
Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade. Options involve risk and are not suitable for all investors.
Futures and futures options trading involves substantial risk and is not suitable for all investors. Please read the Risk Disclosure Statement prior to trading futures products.
Futures accounts are not protected by the Securities Investor Protection Corporation (SIPC).
Futures and futures options trading services provided by Charles Schwab Futures and Forex LLC. Trading privileges subject to review and approval. Not all clients will qualify. Prior to a name change in September 2021, Charles Schwab Futures and Forex LLC was known as TD Ameritrade Futures & Forex LLC.
Forex trading involves leverage, carries a high level of risk and is not suitable for all investors. Please read the NFA booklet Trading Forex: What Investors Need to Know prior to trading forex products.
Forex accounts are not protected by the Securities Investor Protection Corporation (SIPC).
Forex trading services provided by Charles Schwab Futures and Forex LLC. Trading privileges subject to review and approval. Not all clients will qualify. Forex accounts are not available to residents of Ohio or Arizona. Prior to a name change in September 2021, Charles Schwab Futures and Forex LLC was known as TD Ameritrade Futures & Forex LLC.
Charles Schwab Futures and Forex LLC, a CFTC-registered Futures Commission Merchant and NFA Forex Dealer Member. Charles Schwab Futures and Forex LLC is a subsidiary of The Charles Schwab Corporation.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2021 Charles Schwab & Co. Inc. All rights reserved.