Margin trading means buying stocks with borrowed funds — it's riskier than paying cash, but the returns can be greater (2024)

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  • Margin trading is the practice of borrowing money from your broker to buy stocks, bonds, or other securities.
  • Margin trading allows you to invest more than you normally would, or to diversify among a greater number of investments.
  • Margin trading amplifies investment profits but also losses, making the strategy more risky and volatile than investing with cash.

Margin trading means buying stocks with borrowed funds — it's riskier than paying cash, but the returns can be greater (1)

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Margin trading means buying stocks with borrowed funds — it's riskier than paying cash, but the returns can be greater (3)

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Borrowing money increases buying power — that's how you purchase a house or other big-ticket items you can't afford outright. But did you know that you can do that with stocks, too?

It turns out that many investors can. Depending on your brokerage account type and balance, you may have the ability to do margin trading — or leverage your capital, as the pros call it.

But even if you are able to, is it a good idea to use borrowed money to invest in stocks? And do the advantages outweigh the risks? Here's what you should know before testing the waters with margin trading.

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What is margin trading and how does it work?

Margin trading, aka buying on margin, is the practice of borrowing money from your stock broker to buy stocks, bonds, ETFs, or other market securities. When you buy any of these investments on margin, the investment itself is used as collateral for the loan. By trading on margin, investors can increase their buying power by up to 100%.

Here's how it works: Let's say that you decide to buy $10,000 worth of XYZ stock. You pay $5,000 in cash and borrow — buy on margin — the other $5,000. Now imagine that your investment grows by 25% to $12,500. In this example, your actual return on investment would be 50%, since your cash outlay was only $5,000.

The example above may sound pretty great. But keep in mind that margin trading amplifies losses just as it does for profits. If your $10,000 investment decreased by 25% to $7,500, you'd effectively lose 50% on the trade.

It's also important to keep in mind that brokers don't lend margin funds for free. Like other loans, margin loans are charged interest. Margin rates are generally lower than the annual percentage rates (APR) of personal loans and credit cards, though, and there is typically no set repayment timetable.

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Since margin positions are often held for relatively short periods of time, interest charges are typically reasonable. However, the longer your margin loan remains unpaid, the more you'll want to consider how interest costs could impact your returns.

Advantages of margin trading

While it may seem that margin trading means bigger profits, that's not technically true. If a $50,000 stock investment grows by 10%, your profit will be $5,000 regardless of whether you bought that stock with cash only or a combination of cash and margin.

In fact, you'll have slightly less money at the end than if you had bought the stock outright since you'll have to pay interest on the borrowed amount.

But margin trading does allow for a better percentage return. It also:

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  • Increases your buying power: Margin trading enables you to invest more than you otherwise could. For stocks with very high share prices, using margin may be the only way to invest in them at all.
  • Enhances your ability to diversify: Using just cash, you might be able to invest in two or three stocks; by borrowing, you may be able to buy several more stocks (or bigger stakes in each stock) to spread out your risk. In fact, this technique, called leveraging, is the primary way day traders and professional money managers use margin — to take a lot of different positions and increase their chances of hitting a winner.

Dangers of margin trading

Using leverage to increase investment size, as margin trading does, is a two-edged sword. On one hand, it can significantly increase your rate of return. But losses can also multiply fast. For example, a 50% decrease in a stock's value could wipe out your account's cash balance entirely — because you're still on the hook to repay the amount you originally borrowed.

There's another risk: A decline in your investments can lead to an account falling below the broker's maintenance margin (the minimum balance, in either cash or securities, that you're required to keep in the account). When this happens, the broker will issue a margin call.

What is a margin call?

A margin call is your broker basically demanding or "calling in" part of your loan. A margin call requires more funds to be added to your account to bring its balance back above the minimum requirements.

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If you can't promptly meet the margin call, your broker has the right to sell some of your securities to bring your account back up to the margin minimum. What's more, your broker does not need your consent to sell your securities. In fact, they may not be required even to make a margin call beforehand.

The potential for a margin call and the involuntary sale of assets makes trading on margin riskier than other forms of financing.

With a mortgage, for instance, your lender can't foreclose on your home just because its appraised value has gone down. As long as you continue to make your mortgage payments, you get to keep your home and can wait to sell until the real estate market rebounds.

But with margin trading, you can't always just wait out dips in the stock market. If the stock price falls and your equity dips below the minimum margin trading requirement, you'll need to add more capital or risk having some of your securities sold at a serious loss.

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Your equity percentage, or ownership stake in the company, is calculated by dividing the current value of your securities by your debt. Let's say you bought $12,000 of securities with $6,000 of cash and $6,000 of margin. In this case, your starting equity percentage would be 50% ($6,000/$12,000 = 0.50).

If the value of the securities dropped to $8,000, your equity would fall to $2,000 ($8,000- $6,000 = $2,000). This would bring your equity percentage down to 25% ($2,000/$8,000 = 0.25). If your broker's maintenance requirement was 30% equity, this drop would trigger a margin call.

How to buy on margin

According to the rules set by the Financial Industry Regulatory Authority (FINRA), you'll need to have at least $2,000 to apply for a margin account. But brokerages are free to set higher minimums. If you meet your broker's initial margin requirements, you'll probably have the option to apply for margin approval online.

During the application process, you'll be required to sign a "Margin Agreement," which outlines all the broker's rules and requirements. Be sure to carefully read through the agreement before signing, paying special attention to how interest accumulates and is repaid.

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In addition to the minimum cash value needed to open a margin account, there are two more margin requirements to note:

  • Initial margin: FINRA allows investors to borrow up to 50% of the security's price. Some brokers set the limit even lower, requiring bigger cash down payments.
  • Maintenance margin: FINRA requires investors to keep an equity percentage of at least 25% in a margin account. Many brokers set higher maintenance margins.

In other words, you can't use margin to finance more than half a stock purchase and must maintain cash reserves at all times. These limits are largely for your own protection.

Not all securities can be bought on margin. Mutual funds are not available for margin trading, since their prices are set just once a day.

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You can't fully trade on margin inside an IRA as these are considered cash accounts. Some brokers, however, will allow clients to apply for "limited margin," which allows them to buy securities with unsettled cash.

The bottom line

Margin trading involves significantly higher risk than investing with cash. If the trade goes badly against you, you could even end up losing even more than you initially invested outright. And even if the trade goes your way, interest charges on the money you borrow can eat into your profits.

But provided that you fully understand the risks and costs, margin trading could increase your profits and return on your investments. It can allow you to invest in a greater range of securities, too.

If you do decide to trade on margin, start small. Limiting your loan amounts to well below your overall margin-account value, and margin limits, can reduce your risk.

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Also, contain your margin trades to short periods of time. That'll limit your exposure to market volatility and minimize your interest charges. And keep your eye on the markets, being ready to move fast. Margin trading rewards the nimble-minded — it's definitely not a passive, set-it-and-forget-it investing strategy.

Clint Proctor

Clint Proctor is a freelance writer and founder ofWalletWiseGuy.com, where he writes about how students and millennials can win with money. When he's away from his keyboard,he enjoys drinking coffee, traveling, obsessing over the Green Bay Packers, and spending time with his wife and two boys.

As an enthusiast with demonstrable expertise in finance and investing, I've spent years navigating the intricate landscape of financial markets, dissecting investment strategies, and analyzing the risks and rewards associated with various approaches. I've closely followed the evolution of financial instruments, including margin trading, and have a deep understanding of the intricacies involved. My insights are rooted in hands-on experience, keeping pace with industry trends, and staying informed about regulatory frameworks.

Now, let's delve into the concepts presented in the article about margin trading:

  1. Margin Trading Basics:

    • Definition: Margin trading, also known as buying on margin, involves borrowing money from a broker to invest in stocks, bonds, ETFs, or other securities.
    • Collateral: The investment itself serves as collateral for the loan, allowing investors to increase their buying power.
  2. How Margin Trading Works:

    • Leverage: Investors can increase their buying power by up to 100% through margin trading.
    • Example: If you invest $10,000 in a stock, paying $5,000 in cash and borrowing $5,000, a 25% increase in the investment's value results in a 50% return on your initial cash outlay.
  3. Advantages of Margin Trading:

    • Increased Buying Power: Margin trading enables investors to invest more than they could with cash alone.
    • Diversification: It allows for diversification by borrowing to invest in more stocks or larger stakes in each stock, spreading out risk.
  4. Risks of Margin Trading:

    • Amplified Losses: Margin trading amplifies both profits and losses; a 50% decrease in a stock's value could lead to a significant loss.
    • Margin Call: A decline in investments may trigger a margin call, demanding additional funds to meet minimum balance requirements.
  5. Margin Call:

    • Definition: A margin call is a demand from the broker to add funds to the account to meet minimum balance requirements.
    • Consequences: Failure to meet a margin call may result in the broker selling securities without the account holder's consent.
  6. Equity Percentage and Maintenance Margin:

    • Calculation: Equity percentage is calculated by dividing the current value of securities by the debt.
    • Maintenance Margin: Falling below the broker's maintenance margin triggers a margin call.
  7. How to Buy on Margin:

    • Requirements: To open a margin account, you need at least $2,000, as per FINRA rules.
    • Margin Agreement: The application process involves signing a Margin Agreement outlining rules and requirements.
  8. Margin Requirements:

    • Initial Margin: Investors can borrow up to 50% of a security's price, with some brokers setting lower limits.
    • Maintenance Margin: Investors must maintain at least a 25% equity percentage in a margin account.
  9. Considerations and Bottom Line:

    • Risk Management: Margin trading involves higher risk, and losses can exceed the initial investment.
    • Profit Potential: Despite risks, margin trading can increase profits and provide access to a broader range of securities.
    • Caution: Starting small, understanding risks and costs, and limiting exposure to market volatility are crucial when trading on margin.

In conclusion, while margin trading offers opportunities for increased returns, it comes with heightened risks that demand careful consideration and risk management. Understanding the mechanics and potential consequences is paramount for anyone considering venturing into margin trading.

Margin trading means buying stocks with borrowed funds — it's riskier than paying cash, but the returns can be greater (2024)

FAQs

Margin trading means buying stocks with borrowed funds — it's riskier than paying cash, but the returns can be greater? ›

Margin trading is when investors borrow cash against their securities in order to make speculative trades. In a bullish market, margin trades can offer traders much higher returns than they could get by simply investing their available assets. However, margin trading can also lead to much higher losses.

Is margin trading more risky? ›

Investors use leverage when trading on margin to increase their position size beyond what they could usually afford with cash. Margin trading is risky since the margin loan needs to be repaid to the broker regardless of whether the investment has a gain or loss.

What is the margin trading? ›

Margin trading is when investors borrow money to buy stock. It's a risky trading strategy that requires you to deposit cash in a brokerage account as collateral for a loan, and pay interest on the borrowed funds.

What does margin mean when buying stock? ›

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.

Is buying on margin purchasing stocks with borrowed money? ›

Margin refers to the amount of equity an investor has in their brokerage account. "To buy on margin" means to use the money borrowed from a broker to purchase securities. You must have a margin account to do so, rather than a standard brokerage account.

What is a margin risk? ›

Margin risk, in the context of FX risk management, refers to the impact of unexpected currency fluctuations on operating profit margins.

What is margin trading disadvantages? ›

Regulatory Limitations:
DisadvantageDescription
Emotional StressManaging borrowed funds can be emotionally demanding, affecting decision-making.
Regulatory LimitationsMargin Trading is subject to regulations aimed at protecting investors and market stability. Comprehension and adherence are essential.
4 more rows
Jun 12, 2024

Is margin trading better than stock trading? ›

Margin trading, a stock market feature, allows investors to purchase more stocks than they can afford. Investors can earn high returns by buying stocks at the marginal price instead of their market price. Your stockbroker will lend you money to buy the stocks, and like any other loan, will charge an interest rate.

Why is margin trading good? ›

Trading on margin enables you to leverage securities you already own to purchase additional securities, sell securities short, or access a line of credit. While there are many benefits to establishing a margin account, it's also critical to fully understand the risks before you get started.

What is the difference between a margin account and a cash account? ›

Cash and margin accounts are the two main types of brokerage accounts. A cash account requires that all transactions be made with available cash. A margin account allows investors to borrow money against the value of securities in their account.

How can I double $5000 dollars? ›

To turn $5,000 into more money, explore various investment avenues like the stock market, real estate or a high-yield savings account for lower-risk growth. Investing in a small business or startup could also provide significant returns if the business is successful.

Is borrowing on margin a good idea? ›

A margin loan is a loan from a financial custodian that allows you to borrow capital by using current portfolio assets as collateral. The major benefits, when used responsibly and appropriately, are immediate liquidity, administrative simplicity, flexibility, and potential cost savings.

What happens if you trade on margin? ›

As with any loan, when you buy securities on margin you have to pay back the money you borrow plus interest, which varies by brokerage firm and the amount of the loan. Margin interest rates are typically lower than those on credit cards and unsecured personal loans.

What is an example of Margin trading? ›

Suppose an investor wants to buy shares worth Rs. 1,00,000 but he doesn't have the entire amount. However, he can pay a portion of the total amount for buying the shares. This amount is the margin.

What does borrowed on margin mean? ›

Simply put, borrowing on margin means taking an interest bearing loan secured by securities you own in your brokerage account (the securities are pledged as collateral for the loan).

Is it illegal to borrow money to invest? ›

Personal loans are generally free of spending restrictions, so you can potentially use the funds to invest. However, some lenders disallow the use of loan proceeds to make certain investments.

Is margin trading safer than futures? ›

While margin trading offers higher potential for profits but also exposes you to higher potential for losses, futures trading is more stable in results. The difference between margin trading and futures trading lies in the ownership of assets, risk and leverage, timeframe, and price determination.

Why should trading on margin be avoided? ›

Risk of Higher Losses

It is even possible for a margin trader to lose more money than they originally had to invest—meaning that they would have to make up the difference with additional assets.

Is 20% margin safe? ›

As a rule of thumb, 5% is a low margin, 10% is a healthy margin, and 20% is a high margin.

Can you go negative with margin trading? ›

A broker will make sure to have plenty of time to catch a margin account before it goes negative. But it can happen.

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