How Does Margin Work in Trading?
Many investors have heard about trading on margin, but many also ask these questions: How does margin work in trading? Is it a good strategy? Is it risky? Should traders use it? And these are all good questions.
By the end of this article, you should have a solid understanding of how margin works in trading, and you will also have a sense of whether or not trading on margin could be right for you.
It’s important to note upfront that margin trading is a risky strategy. It can multiply your gains on a position, but it can also multiply your losses. Once you see how it works, you’ll have a better understanding of why that is.
What Is Margin Trading?
Put simply, margin trading is the act of borrowing money to invest in a particular stock or security. When you buy on margin, you borrow the money from the brokerage where you place your trades. People buy on margin because it has the potential to significantly multiply gains.
For example, let’s say you have $100 in your brokerage account, and you want to purchase one share of XYZA stock (a fictional stock for this example) for $200.
Since you don’t have $200 in your brokerage account, you can make an arrangement to borrow the difference from your broker. The broker lends you the $100 and you purchase your share of stock.
When you trade on margin, the securities you purchase act as the collateral for the loan. This works the same way as a house does for a mortgage or a car does for an auto loan. If you default on the loan, the brokerage can “repossess” your stock and sell it.
The brokerages that loan the funds get to have some control over how margin trading works. For example, they can decide which particular securities can be traded on margin. They can also set limits on how much a trader can borrow up to a certain federally regulated amount, usually around 50% of the cost of the equity.
How Does Trading on Margin Work?
Trading on margin doesn’t work the same way as trading in a typical cash account. There are special rules and regulations that apply to trading on margin, as well as a number of steps you need to follow.
The first thing you’ll need to do when margin trading is to sign a special agreement with your brokerage firm. By signing a margin agreement, you will be permitted by the firm to open a special margin trading account.
Once you open your new margin account, you can transfer funds into it to get it going. The minimum allowable amount of cash you need to fund a margin account is $2,000, but you can add much more if you so choose.
The Benefit and Drawback of Trading on Margin
The main benefit of trading on margin is that you can increase your gains by a lot. In the above example, let’s suppose that the share price moves up to $250 and you sell. If you had paid for the entire value of the stock by yourself, the return on your investment would be $50 / $200 = 25%. A very good return.
But since you traded on margin, you invested only $100 to purchase the stock. Look at your return now: $50 / $100 = 50% – that’s a whole lot better! You doubled your return on investment.
That’s the positive side of trading with a margin account. So what’s the negative side? Well, just as it magnifies your gains, it also magnifies your losses.
Let’s suppose that the stock fell from $200 to $150 rather than climbing to $250. You sell the stock for a loss. If you had invested the full $200 by yourself, your return on investment would be -$50 / $200 = -25%. But since you traded on margin your loss becomes -$50 / $100 = -50%. Again, that’s a big difference.
Imagine what a 50% loss in your investment would be if you had invested $1,000 instead of $100. What if you had invested $100,000? You’d have just lost a cool $50,000 by trading on margin, which is the danger that comes with margin trading. But on the other hand, the upside can also be large.
How Does a Margin Call Work?
Margin calls occur when a stock declines below your required equity threshold – known as a maintenance margin. When this happens, you either need to deposit more cash or stock in the account or the broker will sell the stock to reclaim their cash.
How far does your stock need to fall before you receive a margin call? Usually 30% to 35% below your equity threshold, though this can vary.
Let’s look back at our example. You have $20,000 of Alphabet in your account, $10,000 of which is your equity and $10,000 of which is on margin. This means you have 50% equity in your account. But if the value of the stock dropped to $12,000, you’d have $12,000 – $10,000 = $2,000 of equity left. This is about 17%, which means your equity dropped by 33% (50% – 17%).
At this point, the drop would likely trigger a margin call, and you would need to bring your equity back up over the maintenance margin by supplying cash or more stock. If you were not able to do so, the broker could sell your collateral stock, and you’d still have to make up for the rest of the loan. This is why trading on margin is generally riskier than trading in a cash account.
Is It Worth It?
Now that you know how margin works in trading, you may be wondering if it’s worth taking on the risk. The answer, as always in these situations, is that it depends.
Every investor needs to decide for themselves whether or not margin trading is right for them. And now that you know what margin trading is and some of its benefits and risks, you can begin to make an informed decision for yourself.
Keep an eye out for our forthcoming article on the benefits of margin trading, which we will be publishing on Investment U soon. Meanwhile, may you trade long and prosper.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.