Investing > Margin Trading Explained

Margin Trading Explained

Trading on margin amplifies risk - but with proper risk management, it can also increase your returns.

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Updated June 11, 2021

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Do you ever find yourself wishing that you had more money on hand to invest?

So do we – it’s a perfectly understandable wish. ✅

To be honest, setting money aside for investing isn’t the easiest (or most fun) thing to do. Yet a bigger trading account gives you more opportunities – and if you’ve ever thought to yourself: “Man, if only I had a few thousand dollars more, I could make a really good move here,” we have some good news for you.

This is where margin trading comes in. Margin trading, or trading on margin, is the process in which you leverage the cash and other assets in your account as collateral to open bigger positions.

Now, don’t get us wrong – if you make a mistake, you’re going to regret it far worse than you would regret the same trade without margin. However, if you practice proper risk management, and don’t overextend yourself, margin trading offers you a fantastic way to grow your account much quicker than you normally could.

Margin is a tool – and like any tool, there’s a proper way to use it, and a wrong way to use it. Just as trading on margin has caused huge swings in the price of Bitcoin, it can also change the value of your trading account rapidly – in either direction.

So, should you trade on margin? It does amplify risk, but if you know what you are doing, and don’t use excessive leverage, it can be a valuable part of your trading arsenal. And to know what you are doing, you’re going to have to understand the ins and outs of margin – but that’s why this guide is here to, well, guide you through the whole process.

What you’ll learn
  • What is Margin Trading?
  • How Does Margin Trading Work?
  • Account Maintenance 101
  • Margin Trading Example
  • Pros and Cons
  • Borrowing Limits in Margin Trading
  • What if I Lack the Funds?
  • Margin in Forex Explained
  • Margin Trading Tips
  • Conclusion
  • Margin Trading FAQs
  • Get Started with a Broker

What is Margin Trading? 💡

Margin trading refers to borrowing money to purchase stocks or other securities. But these aren’t your run-of-the-mill loans – buying on margin entails borrowing money from your brokerage.

Margin trading can allow an investor to purchase more securities, leverage bets, and diversify more than they usually could. Buying on margin also makes it much easier to invest in plenty of blue-chip companies that have expensive stocks. 

However, to no one’s surprise, this isn’t risk-free – that money has to be repaid eventually, and as with all loans, there are interest rates involved. On top of that, if you’ve made a wrong call, you might end up losing more than your initial investment.
To get into margin trading, you’re going to have to open a margin account. The amount of money that your brokerage will be willing to lend you will depend on a couple of factors – the type of security that you’re intent on buying, your cash balance, and the worth of the securities that are in your account.

Trading on margin successfully requires a lot of discipline. A laissez-faire approach to margin trading legislation was one of the causes that fueled the great depression of 1929. You should approach the topic of margin with a fair dose of skepticism and caution – but play your cards right, and you can bolster your gains noticeably.

How Does Margin Trading Work? 🏗

The first step that you’ll need to take in order to trade on margin is to open a margin account. Luckily, most of the leading stock brokerages offer them. Regular accounts allow you to pay for securities with the cash you have on hand – this is why they’re called cash accounts. 

Unlike with cash accounts, which can often be opened without a minimum deposit, the minimum deposit for opening a margin account is universal, due to regulation by the Financial Industry Regulatory Authority (FINRA).

You’re going to have to put up $2,000 to open a margin account. Slight correction – at least $2,000 – while that is the FINRA-regulated minimum, brokerages can demand larger deposits at their own discretion.

The application process for a margin account is rather short – however, it might take a couple of days for your account to get approved. Once it is approved, you can take out your first loan and begin trading on margin.

However, keep in mind that you’re going to have to maintain a certain level of capital in your account to continue trading – this is referred to as maintenance margin, and we’re going to cover it in-depth in the next section.

Another thing that you should be aware of at all times is that margin loans, like all loans, come with interest rates. The interest rates that brokerages charge are based on the current prime rate, and as such are liable to change – however, they are generally quite high. Coupled with the fact that we might soon be seeing an increase in interest rates, the actual amount of interest that you’re going to be paying if you start trading on margin is quite sizable.

If you do decide to trade on margin, you can expect interest rates from 5% to 10% – with the lower end of that spectrum only being available if you choose to invest hundreds of thousands of dollars. However, some brokerages, like Robinhood for example, do offer margin rates that go below 5% – but this is the exception, not the rule.

Margin Trading Account Maintenance ⚙️

In order to maintain a margin account, you have to meet a certain level of value in your account – this is referred to as maintenance margin. The actual amount of capital that you will have to have on hand at all times depends on the value of the positions you’ve opened. Regulation T stipulates that this has to be at least 25% of the total value of the purchased securities.

However, keep in mind that this is the legally mandated minimum – brokerages will often require 30% or 40% as the level of minimum margin. And that shouldn’t come as a surprise – lending that much money out means taking on a huge amount of risk – and even large funds rely on margin.

If the value of the securities that you’ve purchased using margin declines, you’re at risk of receiving a margin call. This happens when you cannot meet the maintenance margin requirements.

Once a margin call is made, you will have a short amount of time (which can vary from a couple of hours to a couple of days) to bring the value of your account above the minimum requirement. This can be done by depositing cash, selling securities, or closing positions. Of course, you can do all of this ahead of time if you see that you’re getting close to breaching the minimum margin requirements.

If you do not resolve the margin call in the allotted time, the brokerage will close your positions and sell the securities in your account until it can bring the value up to the required minimum. You have no choice in the matter – and the brokerage can sell whatever it likes from your account. Unsurprisingly, this should be avoided at all costs.

Margin Trading Example 👇

Okay – we’ve covered the basics as to how everything works in theory. But these are real-world decisions that have real, tangible consequences – so a purely theoretical understanding just doesn’t cut it.

So, we’re going to use an example to make all of this stuff about margin trading a little more understandable and to bring it a bit closer to home. Let’s take a popular stock that’s widely traded and constantly in the news – you’ve probably guessed it, we’re going to use Tesla (TSLA) to illustrate.

Let’s say that you have $50,000 to invest and that it is the 7th of August, 2020. Tesla is currently trading at $290 per share. If you invested $50,000 in Tesla then, you’d be able to buy 172 shares. If you sold them off on the 31st of August, 2020, when the share price climbed to 498, you would have $85,656 in your account.

Now, let’s say that you used margin – this would allow you to invest $100,000 instead of $50,000, and you’d be able to buy 344 shares. If you sold them off on the same date, you’d earn $498 x 344 = $171,312.

TSLAs growth in August 2020
TSLA’s growth in August 2020. Image by TradingView.

Now, you would have to return the money that you borrowed – but even so, when you return the $50,000 you’ve borrowed, you’d still be left with $121,312 – a sum which is a fair bit larger than the $85,656 you could have made without margin.

Of course, you still have to pay the interest rate on the margin that you’ve used – but in this case, that wouldn’t amount to much more than a couple of thousand dollars. However, if the reverse were to have happened, and the stock price dropped, your losses would be amplified as well. 

The Good and the Bad with Margin Trading

Pros

  • Amplified gains
  • Allows for easy diversification and hedging
  • Allows you to invest in high-priced stocks
  • Allows traders to act on opportunities they might have otherwise missed

Cons

  • Amplified losses
  • Interest rates make it more difficult to profit off of trades
  • Minimum balance must be met
  • Risk of margin calls with catastrophic consequences

Advantages of Margin Trading ✅

Margin trading comes with a host of advantages – otherwise, nobody would use it. The most obvious of these is increased purchasing power – allowing you to open bigger positions, as well as allowing you to invest in stocks that have high prices. 

Additionally, access to margin gives you a bit of flexibility – if you’re short on cash, you might end up missing a lot of good opportunities that come your way. If you have a portfolio that is weighed heavily in the favor of one asset or sector, those stocks can be put up as collateral for a loan, and you can use the loan to diversify, thereby hedging your bets.

On top of that, access to margin allows you to increase the rate of the return for the money that you invest. With margin, even a small account in the hands of someone who knows what she or he is doing can experience rapid growth – with the right strategy and risk management, of course.

There are also a couple of smaller benefits to margin trading – interest rate payments for margin may be deductible against your taxable income, for one. Speaking of interest rates, if you don’t exceed the margin maintenance requirement that your broker has in place, you can repay your debts at your own leisure and pace.

Just keep this in mind – margin allows you to put more muscle behind strategies and methods that work. If you don’t have that figured out yet, margin has nothing to offer you – the only wise way to use margin is to amplify something that is already tried and tested.

Risks of Trading on a Margin ⚠️

Just as trading on margin amplifies gains, it amplifies losses. This might not sound too bad at first glance – but consider the fact that even small losses will end up costing you a lot – and large losses can absolutely wipe your account clean. 

You should also keep in mind that even if your investments are showing an increase in price, you still need to make up for the interest rate that you’ll have to pay – put in plain terms, the bar for successful trading is 7-9% higher when it comes to trading with margin.

Not all stocks can be bought on margin. On top of that, you’re going to have to meet a minimum balance to avoid a margin call – this can easily spiral out of control, and if you don’t have spare cash lying around, you’re going to be in a really tough spot. The securities that you own might be marginable, and they may give you some breathing room – however… 

If you fail to meet a margin call, the brokerage can and will liquidate your assets. You don’t need us to tell you that this is catastrophic – it wreaks havoc on both long-term and short-term plans. Margin calls could end up costing you a huge amount in short-term capital gains tax, as well as unrealized profits from investments that are showing signs of recovery or further growth. 

Even if your account has plenty of securities in it, you don’t get to choose which ones get sold off to cover the debt that you’ve accrued. Put another way, margin calls cause you to lock in losses – the opposite of what you want to do. As if that wasn’t bad enough, failure to pay margin loans will cause a hit to your credit score.

How Much You Can Borrow in Margin Trading 💰

The amount of money that you will be able to borrow depends on the asset type that you want to buy. First of all, not all securities are marginable – certain securities that exhibit high volatility, such as penny stocks, OTC stocks, and recent IPO’s cannot be bought on margin – they are non-marginable securities. However, this shouldn’t worry you too much – penny stocks and OTC stocks are incredibly volatile, and IPO’s have been sluggish as of late.

What falls into this category depends on the specific brokerage – but these three types of securities are always non-marginable. Mutual funds, for example, can be bought on margin with some brokerages while others don’t offer that service.

When it comes to stocks, the maximum amount of leverage that can be used is 2:1 – meaning that you can open a position that is worth twice the amount of money that you have in your account – and the same holds true for ETFs and bonds.

Other asset classes have different levels of leverage associated with them. Futures contracts, for example, are usually traded with a leverage of 15:1 – although this might vary a bit depending on the brokerage that you’re using. However, futures often have rough periods – and seeing as how they’re complex financial instruments, we’d recommend waiting until you have a lot of experience before you begin trading them on margin.

VIX JUN Futures Index
As can be seen from the VIX JUN Futures Index, the future market is volatile and prone to violent changes. Image by TradingView.

Forex Trading and Cryptocurrency Margin 💱

With forex trading, leverage of 50:1, 100:1, and 200:1 are all common sights. Cryptocurrencies can also be traded on margin – and the leverage that is offered to crypto traders usually varies from 2:1 to 100:1, although this will understandably vary quite a bit depending on the cryptocurrency in question. Leverage is one of the key factors contributing to the fluctuating price of cryptocurrencies – and has also had a detrimental effect on leveraged tokens.

Another important factor to keep in mind is that brokerages can and do require higher levels of maintenance margin for certain stocks. These are usually volatile stocks that have healthy levels of trading volume – for example, Charles Schwab charged a higher maintenance margin for traders who sought to utilize margin to buy Tesla and AMD shares.

What if I Don’t Have Enough Money for Margin Trading? 💸

There are two things to cover when dealing with this topic – one, what happens if you don’t have enough money for margin trading, and two, can you still somehow benefit from margin trading even if you don’t have the money that is required, or the risk tolerance to support it?

Well, if you don’t have the money for margin trading, you can’t engage in it. Shocking – we know. However, seeing as how margin requirements are relatively low at a sort of humble $2,000, the barrier isn’t that high. 

If you can’t meet those minimum requirements, you shouldn’t even be thinking about trading with leverage – make a budget, look at your income and expenses, keep on learning about investing and the stock market, and invest as much as you can – preferably, in a way that doesn’t involve much risk, such as buy-and-hold investing.

You’ll get there, eventually. There’s no rush – the ability to trade on margin won’t make you a good trader all of a sudden, and it won’t cause a dramatic change in how successful you are. Slow and steady wins the race – the ability to trade on margin is a bonus, not a key feature of investing, you can and will do just fine for the time being without it.

However, there might be a way to still profit off of the phenomenon of margin trading without actually engaging in it – depending on your brokerage of choice. Some brokers offer what is referred to as margin funding – the ability to fund the margin trading of others, in exchange for a guarantee that the loan will be repaid, with interest.

Although that might sound risky at first, the whole thing is overseen by the brokerages that offer such options – and in the event of things going south, leveraged positions can be liquidated, margin calls can be sent – and your money will be returned to you.

What is Margin in Forex? 💹

Margin is a term that is also mentioned frequently in the frantic, fast-paced world of forex trading. Margin in forex functions in a similar way – but there are a couple of differences to keep in mind.

When trading currencies, margin represents the deposit that you have to make in order to open a position. Seeing as how forex traders seek to profit off of the small changes in the exchange rates of two currencies, you have to trade a lot of currency in order to cover the costs of commissions and fees while still making a profit.

Because of this, forex traders use leverage. If you were to trade with say, $1,000, the profits that you could make by trading forex are negligible. However, with margin, your $1,000 will be held or “locked up” as collateral, and the broker will provide you with the rest of the money to open a big position.

And margin rates in forex are huge. For example, if a brokerage offers a 2% margin rate for forex trading (and plenty of the most popular forex brokerages do), you’d only have to put up 2% of the money for a position. In other words, $1,000 would allow you to open a position worth $50,000.

Of course, as it is often said, this is a double-edged sword. It allows you to get a lot more exposure to the market, but just as any potential gains are amplified, so too are potential losses amplified.

If things start to go south, your broker will serve you a margin call – this will either require you to deposit more funds in order to keep the position open, or it will terminate your positions before things get really bad. In the case of extremely volatile markets and huge losses, you run the risk of account termination.

Margin Trading Tips 📈

So, now that we’ve handled all the abstract information and theory behind margin trading, hopefully, we have a solid foundation for something a bit more concrete – real, actionable advice.

Here are some of the most useful tips to keep in mind when trading on margin – if you make sure to stick to these religiously, the chances that you’ll make a huge mistake and accrue big losses are significantly reduced.

Start Slow ⏳

So, you’ve opened an account with a good brokerage, funded it, made some trades, and you’ve decided that it’s time to open a margin account. You do that, you read up on margin, and you’re ready to take advantage of this new tool in your arsenal.

So you go out and use as much margin as you can, right? Wrong – we know we’ve said this like ten times, but trading on margin is risky. Even if you’re an experienced investor, if you haven’t done it before, you still need to develop a feel for margin trading.

Start slow – you’re not in a rush. On top of that, start low – use a little margin in the beginning, and slowly work your way up as you develop a feel for this style of trading. This will give you the necessary time to adapt to the more high-stakes nature of margin trading, as well as ample time to develop, tweak, and test strategies.

Know the Ins and Outs of the Rules 🧠

Before you start actually trading on margin, you have to have a flawless grasp of the rules. How much leverage is available to me for different security types? How long does my brokerage give me to resolve margin calls, should the need arise?

How much interest does trading on margin accrue – how much will my trades have to make in order for me to actually profit? How much leeway do I have, seeing as how the value of the securities in my account will fluctuate? If I can’t resolve a margin call in time, how much money will I lose?

These aren’t things that you can resolve on the go – you should know exactly what you’re getting into before you start margin trading.

Keep It Brief 📆

Once you’ve purchased a security on margin, hopefully, all goes well – and you’re going to reach that delightful stage where you’re seeing your risk pay off. Although it can be tempting to slug it out for a little while longer, you should refrain from doing this – sometimes, even if all the signs point that the stock price will continue to climb.

Stay Cool and Don’t Rush In 🥶

Because trading on margin amplifies the profit potential of trades, it’s easy to get swept up in the current of emotion. “But if I hold for a couple of more days, think of the money I could make” or “It’s been a bad day for this stock – maybe I should sell before it drops even further.”

These are perfectly understandable reactions – but they’re far from perfect. Trading is a rational game – there’s no space for emotion, positive or negative. You should always stay cool – and keep the lessons of trading psychology in mind at all times.

A lot of the rollercoaster of emotions can be avoided if you simply prevent yourself from rushing in. Sure, a promising trading signal or a stock that’s generating some buzz might be tempting – but sooner or later, you’re going to lose the thread, and you’ll end up two steps behind what is actually happening, with no hope of catching up. Stock trading has changed – hype and social media are undeniably influential, but they’ll never trump fundamentals.

Make decisions with purpose and intent. Research and a clear goal trump hair-trigger reactions 100% of the time. Always know exactly what you’re doing, why you’re doing it, and what the parameters of success and failure are for each choice that you’ve made.

Keep an Eye on Your Investments 👀

If you’re used to good old-fashioned buy-and-hold investing, or simply trade stocks with a longer timeframe, you might not be used to keeping a watchful eye on your investments. However, if you’re trading on margin, you really have to.

With other forms of investing and trading, you have the luxury of waiting to see if a decrease in stock price is temporary – maybe you can ride it out, or you’ll end up selling regardless. You can’t do that with margin trading – as even small decreases in the underlying security’s price can lead to large losses.

When you trade with margin, you can end up losing more than the entire value of your account. Risk-management and cutting your losses are the name of the game here – and all of that requires the pretty-much constant supervision and monitoring of your investments. Luckily, price alerts, stock trading mobile apps, and other software solutions make this much easier than it used to be.

Avoid Margin Calls like the Plague 🚨

As we’ve established, margin calls are bad news. They have to be resolved quickly, stop you from opening new positions, and could easily end up costing you quite a bit of money.

Don’t go overboard with leverage. Keep a healthy cash reserve in your account – that way, the fluctuating prices of securities are much less likely to trigger a margin call. 

We’re not exaggerating when we say that you should avoid them like the plague – just look at what happened with Archegos Capital Management. Margin calls cause you to lock in losses and can trigger huge, unnecessary short-term capital gains tax bills.

Use Stop Orders ✅

The biggest risk that you’re exposing yourself when trading on margin, by far, is that the securities you buy will see a drop in price and that you’ll not only end up with $0 in your account but actually end up in debt.

However, you’re not totally on your own once you decide to pull the trigger and buy something using margin. You can – no, scratch that, you should, always, use stop orders – as they offer you a simple, straightforward way to mitigate any potential losses and save yourself from utter ruin – and they take the guesswork out of damage control.

Stick to Your Price Targets 🎯

When you’re trading stocks, it’s easy to get greedy – and it’s all the easier when you’re able to open a much bigger position than you normally would. But don’t get swept up in that sentiment – take your wins when you can.

The easiest way to lock in profits is by setting and sticking to price targets. We know – the possibility that a stock you’ve bought on margin might see a further increase in price is hugely tempting – but the risk isn’t worth it. If things go south, you won’t only lose your profits, but you can zero your account. Be smart – take the wins that you’ve earned before they turn sour.

Conclusion 🏁

If you’ve made it this far – thanks for sticking with us. Margin trading is an important, complex topic – and we hope we’ve managed to bring it closer to you in a lighthearted, easy to understand, and enjoyable way. You’ve made the right call – this is one segment of investing that you should definitely understand quite well before you get into it.

By itself, margin won’t make you a better or worse trader. But if you’ve done the research, put in the effort, and earned some stripes as an investor or trader, it can be a very useful part of your toolkit that can open up interesting, profitable new possibilities. We hope that you’ll manage to successfully leverage (see what we did there?) this knowledge to your benefit.

Margin Trading FAQs

  • What Triggers a Margin Call?

    A margin call is triggered when the value of your account drops below a certain level that is referenced to as maintenance margin. Once that happens, you will have a short amount of time to resolve the issue.

  • How Do You Satisfy a Margin Call?

    To satisfy a margin call, you have to bring the value of your account up above a certain level. This can be done by depositing cash, putting more securities in the account, selling securities in the account, and closing positions.

  • How Dangerous is Margin Trading?

    Margin trading has the potential to be very dangerous. Meeting a margin call can easily deplete your cash reserves and savings, and failing to meet a margin call will cause you to lock in losses and can easily result in a rather large and unnecessary short-term capital gains tax bill.

  • What Cannot Be Purchased on Margin?

    In general, penny stocks, OTC stocks, recent IPO’s and mutual funds cannot be purchased on margin - although the list of non-marginable securities might be shorter or longer depending on the specific brokerage in question.

  • Can You Buy Options on Margin?

    Yes - you can buy options on margin, however this is an incredibly complex trading method, and requires a lot of know-how and experience.

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