Margin trading, or buying on margin, involves getting a loan from your broker to buy stocks. This leveraged trading strategy amplifies your returns when you get lucky – and your losses when you don’t. And if the value of your margin account declines too far, your broker can sell your securities out from under you.
When you trade on margin, you’re borrowing money from your brokerage to buy stocks – effectively, taking out a loan. You use the loan to purchase securities and hold them in a special account, called a margin account. Then, you repay your loan (plus interest).
Margin trading takes advantage of leveraging debt. On one hand, trading with leverage means you can buy more stock than you could afford alone. But if your margin account tanks, you lose the value of your investments and your loan.
Before we go any further, let’s define a few essential margin trading terms that we’ll run into below:
To start margin trading, you need a margin account. This is a specialized brokerage account that allows you to borrow money from your broker to buy securities. Any cash or securities in your margin account then become collateral for your loan.
When you’re ready to cash out, you sell your positions, pay off your loan, and pocket the profit. (Assuming all goes well…which is never a guarantee.)
However, you can’t just open a margin account and trade willy-nilly. In fact, margin trading is strictly regulated by the Federal Reserve, FINRA, and the SEC.
Basic regulations include:
Together, these rules ensure that investors maintain skin in the game while limiting risk. But don’t be fooled: you can still lose money – and a lot of it – margin trading.
The Federal Reserve Board regulates which securities investors can trade on margin.
Generally, penny stocks, initial public offerings IPOs) and over-the-counter stocks can’t be margined due to their added risks.
Additionally, mutual funds aren’t eligible for margin trading. Most IRAs also don’t permit margin trades, though some offer “limited margin” alternatives using unsettled cash.
Individual brokerages can also set more specific limits, such as excluding a particular industry, market cap or company.
When you borrow money from a brokerage to buy securities, you’re taking out a margin loan. These are considered secured loans because they use the stocks you purchase as collateral. Additionally, you must open a margin account to use for trading before borrowing money.
Note that, like other loans, margin loans carry interest rates that increases the cost of borrowing. But unlike other loans, you can usually keep your loan open as long as you want. (Assuming you keep up on your interest payments.) Then, when you sell your securities, the brokerage pays off your loan first and hands you any remaining profits.
The biggest risk in margin trading is that your margined securities will lose value. Because these securities serve as loan collateral, you’re required to keep a certain amount of cash in your account to hedge against declines. (That’s your maintenance requirement level.)
When your securities do lose value, the loss is pulled from your equity. If your account value declines below the maintenance levels, your broker will issue a margin call. Generally, you have 2-5 days to deposit more cash or sell off securities to bring your account in line.
If you fail to meet your margin call, your broker can forcibly sell your securities to bring your account back within acceptable parameters. Worst of all, you have no say in which securities they sell. And if you happen to incur any short-term capital gains along the way, you risk triggering a hefty tax bill.
Say that you buy $10,000 in stock in a margin account. You deposit $5,000 of your own funds and borrow $5,000 from your broker. In other words, you’re 50% leveraged.
Now let’s say that the value of your account rises 30% to $13,000. You can sell your shares, pay off your $5,000 loan, receive your $5,000 original investment, and still profit around $3,000. (Minus any loan interest.)
If you’d only invested your initial $5,000, you’d have only walked away with half that. But thanks to the power of leverage, you’ve doubled your profit potential.
Suppose instead your account value drops 30%. Now you’re only worth $7,000. Worse, because the losses come out of your equity, your portion of the account is only worth $2,000. All of a sudden, you’ve lost 60% of your investment overnight.
Worse, since your broker sets a maintenance margin of 40%, you’re now facing a margin call. If you can’t deposit more cash, your broker will sell your stock, pocket their $5,000, and leave you with $2,000.
In other words, they’ll be made whole – and you’ll lose $3,000. Therein lies the risk of using leverage to trade stocks.
Margin trading carries unique pros and cons due to its use of leverage. A good bet can produce bigger gains than you’d ever achieve on your own. But a bad one can just as easily produce enormous losses.
If you want to open a margin trading account, you’ll need to first meet the minimum deposit requirement. Though FINRA sets the rock-bottom minimum at $2,000, brokerages may set higher limits.
Once you have the funds ready, you can apply for a margin trading account with a broker in person or online. During the application process, you’ll have to provide various personal and financial information.
You’ll have to sign a Margin Agreement outlining your broker’s terms. Pay special attention to this document, as it outlines factors like interest accumulation and any repayment schedule requirements.
Once you’ve opened the account, you can deposit your funds and select assets to start trading. Most non-penny stocks are eligible for margin trading, though your brokerage may set more specific limits.
Margin trading involves taking out a loan to buy stocks. While these activities present risks separately, these risks compound when combined. For most investors, margin trading presents too much risk to be compatible long-term investment strategies.
Because margin trading success requires selecting securities that rise in price relatively quickly, selecting the “best” stocks is nearly impossible. At best, traders can make educated guesses about which stocks or industries are likely to outperform short-term. However, there are no guarantees.
Technically, there is no “safe” level of margin trading, as you always risk losing more than you initially invested. You should never margin more than you can afford to lose. Stop-loss orders can help limit your downsides by selling stocks when they reach a minimum price level.
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