Margin Trading

Margin Trading

Margin trading refers to the practice of using borrowed funds from a broker to trade a financial asset, which forms the collateral for the loan from the broker. Since such use of financial leverage can potentially magnify gains but could also saddle the trader with devastating losses, leverage has the well-deserved reputation of being a double-edged sword. 

Because of the heightened risks of margin trading, it can only be conducted in a type of account known as a margin account, which differs from the regular cash account used by most investors. While stocks can be purchased either in cash or margin accounts, short sales can only be made in margin accounts; as well, certain instruments like commodities and futures can only be traded in margin accounts.

Margin refers to the amount of funds that the trader or investor must personally put up from his or her own resources, and can vary widely depending on the asset or instrument. For instance, currency futures typically need a margin that amounts to a low single-digit percentage of the currency contract’s value. A stock bought on margin generally requires the investor to supply 30% to 50% of the value of the purchase transaction. As a rule of thumb, the greater the volatility of the stock, the higher will be the margin requirement.

Margin trading is risky business, and therefore is governed by rules set by a number of entities – the Federal Reserve Board, self-regulatory organizations (SROs) such as the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority (FINRA), and brokerage firms.

The NYSE tracks the total amount of margin debt – which is debt taken on in a margin account – on the exchange. As of end-September 2017, margin debt on the NYSE was a record $559.6 billion, which is to be expected as U.S. equity indices were also near all-time highs, and stock market peaks and record levels of margin debt often coincide. However, long-time market watchers find it disconcerting that previous peaks in margin debt on the NYSE occurred in 2000 and 2007, a few months before U.S. stocks embarked on major corrections. Very high levels of total margin debt can pose a systemic risk to the economy, because sliding stocks force investors to sell shares to meet margin calls (discussed later here), which exacerbates downward pressure on stock prices and can result in a market crash.

Margin Trading: What Is Buying On Margin?

Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account.

By law, your broker is required to obtain your signature to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin. Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It's essential to know that you don't have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.

You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid. Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it's known as a margin call. We'll talk about this in detail in the next section.

Borrowing money isn't without its costs. Regrettably, marginable securities in the account are collateral. You'll also have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.

Therefore, buying on margin is mainly used for short-term investments. The longer you hold an investment, the greater the return that is needed to break even. If you hold an investment on margin for a long period of time, the odds that you will make a profit are stacked against you.

Not all stocks qualify to be bought on margin. The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers will not allow customers to purchase penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the day-to-day risks involved with these types of stocks. Individual brokerages can also decide not to margin certain stocks, so check with them to see what restrictions exist on your margin account.

A Buying Power Example

Let's say that you deposit $10,000 in your margin account. Because you put up 50% of the purchase price, this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and haven't tapped into your margin. You start borrowing the money only when you buy securities worth more than $10,000. 

This brings us to an important point: the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account. Later in the tutorial, we'll go over what happens when securities rise or fall.

Margin Trading: The Dreaded Margin Call

As the concepts of maintenance margin and margin call are vital to understanding how a margin account works, we demonstrate these with an example below.

Let’s say you open a margin account with $5,000 of your own money and $5,000 borrowed from your brokerage firm as a margin loan. You purchase 200 shares of a marginable stock at a price of $50; under Regulation T, you borrow 50% of the purchase price. Assume that the maintenance margin requirement (MMR) is 30%. (Related: What happens if I cannot pay a margin call? and Do you have to sell your stocks when you get a margin call?)

The Table below shows the changes in the margin account as the stock price fluctuates over time. Note that as the current stock price falls below the purchase price, account equity gets steadily eroded, culminating in a margin call when the shares are trading at $35.

What is the exact stock price below which a margin call will be triggered? This occurs when Account Equity equals the Maintenance Margin Requirement. Mathematically this translates into the stock price at which:

Account Value = (Margin Loan) / (1-MMR) 

In this example, a margin call will be triggered when the account value falls below $7,142.86 (i.e. margin loan of $5,000 / (1 – 0.30), which equates to a stock price of $35.71.

When the price of the stock that was purchased at $50 falls to $35, it triggers a margin call of $100. You therefore have one of three choices to rectify your margin deficiency of $100:

Deposit $100 cash in your margin account, or

Deposit marginable securities worth $142.86 in your margin account, which will bring your account value back up to $7,142.86, or

Liquidate stock worth $333.33; with the proceeds used to reduce the margin loan; at the current market price of $35, this works out to 9.52 shares, rounded off to 10 shares.

The value of shares to be liquidated can be calculated by the following relationship:

Liquidation Value = Account Value – (Account Equity / MMR)

Thus, Liquidation Value in this case is: $7,000 – ($2,000 / 0.30) = $333.33

When the stock price falls to $30, the margin deficiency increases to $800. The choices you have to meet your margin call are:

Deposit $800 cash in your margin account, or

Deposit marginable securities worth $1,142.86 in your margin account, which will bring your account value back up to $7,142.86, or

Liquidate stock worth $2,666.67; with the proceeds used to reduce the margin loan; at the current market price of $30, this works out to 88.89 shares, rounded off to 89 shares.

Example of Maintenance Margin and Margin Call

*MMR = Maintenance Margin Requirement

If for some reason, you are not aware of the margin call or cannot meet the margin call, your broker has the right to liquidate stock in the amounts shown without further notice to you.