Margin Trading Explained - WealthFit (2024)

There’s more than one way to buy stocks.

Although by far the most common, you do not always need to transfer cash into your account to purchase securities. Instead, you can borrow money from your brokerage company and use the extra funds to buy additional assets.

This is called margin trading.

Margin trading allows you greater flexibility and the potential for higher returns. But, here’s the catch: You can also potentially lose significantly more money in a relatively short period of time. This is the result of leverage.

Here’s everything you should know about margin trading.

What is Margin Trading

Margin trading (aka “buying on margin”) means borrowing money from your brokerage company to buy stocks or other assets.

It’s not about what you trade, it’s about how you trade.

Essentially, you’re taking out a loan and using whatever securities you purchase as the collateral for the loan.

Like all loans, you will eventually have to repay that loan, usually with interest, at a later date.

Your brokerage will determine which assets can be traded on margin and up to what amount you can borrow with a margin loan.

Depending on the size of your account and your history with your broker, your margin limit will vary.

Advantages of Margin Trading

Succinctly, here are the greatest advantages to margin trading:

• Significant leverage which can greatly bolster returns
• The ability to profit from share price decreases (short selling)
• A convenient line of credit with repayment flexibility
• Tax-deductible interest (if interested, talk to a tax professional)
• Access to trade advanced options strategies

Disadvantages of Margin Trading

Stock prices are constantly fluctuating and can quickly put margin traders in a bind if the price of a security falls.

Here are a few of the most conspicuous disadvantages to margin trading:

• Being forced to quickly lock in losses to prevent further drawdowns. This is especially painful when the stock recovers and climbs higher shortly thereafter
• Margin rates are typically in the 7-9% range, forcing your investments to outperform the high bar of the interest rate you’re paying on the loan
• Exposure to greater losses and the ability to lose more than your initial investment.
• Margin calls
• Increased stress, for all of the aforementioned reasons (and more)

Margin Trading Example

Let’s say you want to buy 200 shares of XYZ stock that’s currently trading for $20 per share, but you only have $2,000 in your brokerage account.

You decide to use that $2,000 to buy 100 shares and buy the other 100 shares on margin by borrowing an additional $2,000 from your brokerage.

This gives you a total investment of $4,000.

If the price of XYZ doubles to $40 per share, your total investment is now worth $8,000.

You return the $2,000 you borrowed and keep the total gain of $4,000.

Had you invested only your cash, your gain would have only been $2,000.

Trading on margin allowed you to double your profit.

But, if after purchasing on margin, the price of XYZ falls to $10 per share, the value of your investment is cut from $4,000 to $2,000.

After repaying the $2,000 loan, you’re left with nothing — a full $2,000 loss.

With margin, you can lose more than your initial investment. If the price fell to $5 per share, your investment would be worth $1,000.

Not only did you lose the entire purchase amount, you’ll need to deposit an additional $1,000 to satisfy the margin loan.

Note: The above examples do not include the interest you will owe on the borrowed margin, regardless of the results of the trade.

Requirements for Margin Trading

To be approved to trade on margin, your account typically must have at least $2,000 in cash equity or eligible securities and a minimum of 25-40% of its total value as equity at all times, depending on the brokerage.

If you own $100,000 worth of stocks, you must have at least $25,000 worth of cash in the account (with the remaining $75,000 potentially being loaned on margin), assuming your broker only requires 25%.

What is a Margin Call?

A margin call is when your broker asks you to place additional funds in your account because the value of your account dropped below a specified threshold.

This threshold is usually 25-40% of the total value of the account, as mentioned above.

Unlike a home or car loan, the value of the collateral (stock prices) when margin trading can decrease significantly, requiring you to make up for the lost collateral.

Your brokerage is not required to notify you of a margin call, and don’t have to give you time to add money to your account.

If not promptly taken care of, your broker is permitted to sell the shares of its choosing to make up the difference in the equity you’re short.

The Bottom Line: Margin Trading

As with all forms of leverage, margin trading offers potential for both opportunity and calamity.

For investors who understand and know how to use it, trading on margin can significantly increase returns and offer the ability to diversify far more than they otherwise would be able.

However, it comes with significant risks that are hard to quantify until you experience them firsthand.

Only you will know if margin trading is right for you, based on your exact situation and personal risk tolerance.

If you do decide to take the plunge, remember these words from Warren Buffett: “Never test the depth of the river with both feet.”

Proceed with care.