Investors who want to borrow money from a brokerage to buy securities do it through margin trading. Unlike a regular cash account, where you can only make purchases with the money you have on hand, a margin account allows you to leverage your investments, potentially increasing your gains, but also your losses. It’s a strategy best suited for seasoned traders who understand the high level of risk involved.
This guide will teach you what margin trading is, how leverage works, the potential upsides and downsides, and the risks associated with this advanced trading technique.
- How Margin Trading Works
- Upside Example
- Downside Example
- See All 6 Items
How Margin Trading Works
With margin trading, an investor uses a combination of their own money and borrowed funds from a brokerage to make trades. The borrowed money is provided through a margin account, which acts as a line of credit. The borrowed money is collateralized by the securities that are already in the account.
When you open a margin account, the brokerage sets a maintenance margin, which is the minimum amount of equity you must maintain in the account, typically a percentage of the total value of your securities. If the value of your securities falls below this level, the brokerage will issue a margin call, requiring you to deposit more cash or sell some of your holdings to bring your account back up to the required maintenance margin.
Leverage is the key component of margin trading. It’s the ability to control a large amount of a security with a relatively small amount of your own capital. For example, if you have a 2:1 leverage ratio, you can buy $20,000 worth of stock using just $10,000 of your own money. This amplifies both potential profits and losses.
Upside Example
Suppose you have $10,000 in your margin account and the brokerage allows you to borrow another $10,000, giving you a total of $20,000 to invest. You use the money to buy 200 shares of stock priced at $100 per share.
If the stock price rises to $125 per share, the value of your investment is now $25,000. After repaying the $10,000 you borrowed, you’re left with $15,000 — a 50% return on your initial $10,000 investment.
Downside Example
Consider the same scenario, where you have $10,000 and borrow another $10,000 from your brokerage.
You purchase 200 shares of stock for $100 per share, but this time the price falls to $75 per share. The value of your investment is now $15,000. After repaying the $10,000 you borrowed, you’re left with just $5,000. You’ve lost 50% of your initial investment.
Risks and Suitability
Margin trading significantly increases the risk of an investor’s portfolio. The amplified gains can be tempting, but the risk of losses is what makes this a strategy for advanced traders only.
A sudden market downturn can lead to a quick margin call, forcing an investor to sell their holdings at a loss or inject more cash. This can result in a total loss of the initial investment and, in some cases, even a debt to the brokerage.
Because of the complexity and potential for rapid and substantial losses, margin trading isn’t suitable for beginners. It requires a deep understanding of market trends, a strong risk tolerance and the ability to manage a portfolio actively.
Weighing the Risks Against the Rewards
Margin trading is a high-risk, high-reward investment strategy that uses borrowed money to increase an investor's purchasing power. While it can magnify profits during a market upswing, it can just as easily magnify losses, potentially leading to a margin call and the erosion of an investor's capital. Using leverage is the primary driver of the amplified risk.
It’s an advanced financial tool best left to experienced investors who have a sophisticated understanding of market dynamics and a high tolerance for risk. It’s not recommended for new investors who are still learning about market fundamentals and getting a sense of their own risk profile.
Frequently Asked Questions
What is a margin call?
A margin call is a demand from a brokerage for an investor to deposit additional funds into their margin account or sell off securities to bring the account back up to the required minimum equity level. It happens when the value of the securities in the account drops significantly.
How much can you borrow in a margin account?
The amount you can borrow varies by brokerage and regulatory rules. The Federal Reserve’s Regulation T allows you to borrow up to 50% of the purchase price of the securities you want to buy. This is known as the initial margin.
What’s the difference between a margin account and a regular cash account?
A regular cash account requires you to have the full amount of money in your account before you buy a security. A margin account allows you to borrow money from your brokerage, using the securities in your account as collateral, to increase your purchasing power.
