What is margin trading? Here’s a quick guide on how to get started without taking on unnecessary risks.
A general rule of thumb in investing is if you go long, you can only lose what you put in. After all, a stock can only drop to zero, right? Your call option can only lose what premium you paid for it … right? The worst-case scenario here is a hefty tax write-off for the year, and a reminder that beating the market is more difficult than it seems.
As with many things related to money, the answer is, “It depends.” There is actually a way to lose more money than you have. With this strategy, you could potentially owe money should you incur a large loss. Or, in an alternate universe where you’re a successful multimillionaire trader, you could be multiplying your gains by two or three times. How is this possible?
What is margin trading?
Simply put, you’re borrowing money (from your broker, not from a loan shark) to invest with. Margin itself is the difference between the value of what you invest in and the loan amount from a broker.
How is trading margin calculated? For example, let’s say there’s a stock worth $1,000. You want to buy it but only have $500, or only want to put up $500 of your own cash. You can open a margin account with your broker and apply for 2-1 margin buying power. In this case, you’re borrowing another $500 to buy the $1,000 stock. In other words, your initial margin is 50%.
What are the benefits and risks of trading on margin?
The benefits of trading on margin
The main benefit is the ability to magnify your gains using debt, called leverage. Let’s take it back to the scenario described above to see how margin trading works.
Assume the stock moons to $1,500 a share and you sell for a profit. Because you only deposited $500 of your own capital, your return would be 100%:
$1,500 share price sold at – $500 margin you have to pay back – $500 initial investment = $500 return
Compare this to a scenario where you invested without margin by just buying the share fully in cash for $1,000. If the shares rose to $1,500 and you sold for a profit, your gain here would be $500. Against your initial investment of $1000, this would be a 50% return.
The drawbacks to trading on margin
Unfortunately, this is a slight oversimplification. When you trade on margin, you also have to pay interest on the amount loaned to you. After all, you are borrowing money from your broker, and like Milton Friedman once said, there’s no such thing as a free lunch. Different brokers will charge different margin interest rates, so it’s important to shop around for the best deal. An excessively high interest rate can cripple your gains.
The risks of margin trading doesn’t just end with interest rates though: A far more dangerous risk called a “margin call” exists.
Let’s use our previous example where you borrowed $500 to buy a $1,000 stock. If the value of your margin account (all cash and securities you hold) falls below a certain percentage, called a maintenance margin, you will face a margin call.
To understand how this works, we need to know a few things. Firstly, the Financial Industry Regulatory Authority (FINRA) sets the minimum maintenance margin at 25% of the total value of a margin account. Some brokerage firms will require more than this, with maintenance margin limits of anywhere between 30% – 50%. Back to our example:
- Say your brokerage firm’s maintenance margin is 50%, and the $1,000 stock is all you own. Your maintenance margin is $500.
- If the stock crashes to $300 (a $700 loss), you will unfortunately be hit with a margin call.
Since you still owe your broker a $500 loan, and you don’t have the cash or stocks to sell to pay for it, the broker is SOL (spreadsheets out of luck, that is). When this occurs, your broker will issue a margin call, which is basically a polite demand for you to either deposit more money to your account, or sell other securities to post the required collateral.
If you do not meet the margin call within a given timeframe, your brokerage has the right to sell other securities in your account. It can do this without your permission or choice of which positions to liquidate … sort of reminiscent of the first episode of Schitt’s Creek.
Frequently asked questions about margin trading
Before you decide whether or not to try it, give these commonly asked questions and answers a read first.
How do I get approved for margin trading?
The requirements for opening a margin account differ by brokerage. First of all, it requires your informed consent. Trading on margin is an inherently risky activity, and when you open a margin account, you should absolutely read all the terms and conditions.
The margin account application is a privilege, not a right. Like applying for a mortgage or car loan, the brokerage will review your financial circumstances. You will be asked to submit details on your annual income, liquid net worth, trading knowledge, and maybe credit score. This is so the brokerage can assess your degree of credit risk before they determine whether or not it is safe to loan money to you.
Finally, most brokers will require a minimum initial deposit—called a minimum margin—of at least $2,000. This value must be maintained in the account whenever you open a long or short position with borrowed funds.
Should I trade on margin?
Remember how I said, “It depends” earlier? Whether you should trade on margin depends on your investment objectives, risk tolerance, and time horizon.
These include investors looking to trade futures and forex, or swing- or day traders trying to maximize short-term gains. In this case, setting stop losses and taking profits is crucial to avoiding margin calls.
Investors with a long time horizon can also consider modest (20% or less) amounts of leverage on a stable portfolio of index funds. The risk of a margin call is greatly reduced when the underlying security is a broad-based index like the S&P 500 as opposed to an individual stock. Over a long period of time, these assets tend to trend upwards, even when leveraged.
In this case, if you keep the margin use low and are able to pay down the interest, you can juice your gains without incurring too much risk of a margin call. Adding a non-correlated volatile asset like long-term US Treasurys or a hedge like out-of-the-money (OTM) put options can further enhance your downside protection, but may potentially eat into returns. Milton Freidman didn’t exactly say this one, but there really is no free lunch outside of diversification.
You can also invest with leverage using other types of financial instruments.
Beyond borrowing money from your broker, there are other ways to leverage your investment, such trading options or buying leveraged exchange-traded funds. Both of these options produce a different risk profile compared to margin, with new advantages and disadvantages.
I don’t want to sleep tonight. Tell me a horror story about margin trading.
Buckle up, this story is a hilarious one. From the degenerate halls of the r/WallStreetBets subreddit came a trader by the name of u/Adderallin, whose risk-taking appetite knew no bounds.
To make a long story short, our hero used a $400k margin position, financed with a SPX short box spread to spend $3.2 million on two 3x leveraged ETFs, which theoretically should have offset each other due to the slight negative correlation between them.
For those of you who don’t understand how risky this is, imagine throwing a parachute out of a plane, then jumping after it, only to realize that the parachute was in fact a laptop bag. Compulsive gamblers look at this man and shake their heads in disgust.
The result? A $276k margin call from TD Ameritrade. The damage was so bad that TD Ameritrade actually changed its risk management policies. Now this story is on the extreme end of things (even for r/WallStreetBets), but it goes to illustrate the no. 1 danger of margin trading: You could owe much more than what you put in if things go wrong.
A final word on margin trading
Margin trading isn’t a “do or die” concept. If your broker extends you generous margin limits with good interest rates, it’s a good idea to not use all of it on a single risky trade. As with many things in life, moderation is key. It’s not exactly “YOLO or use no margin.” Practicing good risk management by sizing your positions accordingly, deploying modest amounts of leverage, and ensuring you have good short-term liquidity to meet any margin calls can set you up for success.