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Margin trading is an activity that involves the use of debt when placing trades in financial markets. Most brokers nowadays offer access to this service and charge an interest rate for investors who opt to use it.
Is it a good idea to use debt when trading in the markets? How can an investor use leverage in his trading account, and how much does it cost? In this article, we discuss this subject and provide our readers with an overview of how margin trading works.
What Is Margin Trading?
Margin trading consists of borrowing money from a brokerage firm to open a position on a certain financial asset. The primary purpose of this activity is to enlarge the potential gains that may result from the investment. However, margin trading also expands the losses in case the position moves in the opposite direction that the investor expects.
Investors who use margin to place trades have to pay interest periodically on the funds they have borrowed. Brokers are obligated to disclose the interest rate they charge on margin accounts. Typically, the interest rate decreases as the amount of the margin loan increases.
How Does Margin Trading Work?
The first step to trading on margin is to open an account with a brokerage firm that supports this activity. Brokers typically require a minimum deposit of $2,000 from customers for this purpose.
Once the account is opened, the investor will be able to place trades that exceed the equity value of the account. The interest charges generated by the borrowed funds will be deducted from the account balance by the end of every month in most cases.
The equity within the account will act as collateral for the loan. If the value of the equity falls below a certain threshold known as the minimum maintenance margin, a margin call could be triggered.
If this happens, a portion of the financial instruments held in the account might be immediately sold to reduce the amount of the margin loan, so the percentage of equity in the account remains above the maintenance margin.
To avoid being liquidated, the investor can also opt to deposit more money into the account to raise its equity value.
The minimum margin is an amount that every investor must deposit in the cash account to be able to open a margin account. The bare minimum required by brokers in the United States is $2,000, although some firms may require a higher amount depending on their risk management protocols.
The initial margin is the minimum percentage of equity that the investor must have available for every trade. In the case of the US, the usual initial margin is 50%, meaning that an investor must have $1 in equity for every $2 they will invest in certain security.
It is important to note that initial margins may vary from one instrument to the other depending on their appraised risk and volatility. Some instruments are not eligible for margin trading, as is the case of options and OTC stocks.
Most brokers display the account’s buying power and update it in real-time based on how the value of the account’s portfolio of assets fluctuates. The buying power is the maximum amount that an investor can allocate to different financial instruments based on the equity value of the account and an estimated initial margin — typically 50%.
If an investor has deposited $10,000 into a margin account and, assuming the initial margin is 50%, the account will have a buying power of $20,000. If the investor allocates $7,500 to different stocks, the buying power will now be reduced to $12,500.
The maintenance margin is the minimum percentage of equity required in relation to the value of the account’s portfolio. If the equity value falls below this percentage, the brokerage will typically issue a margin call.
A margin call requires that the investor deposits more money into the account to increase the equity value above the maintenance margin or that the account holder sells a portion (or all) of the assets held in the account to reduce the debt to achieve the same goal.
As per US regulations, the minimum maintenance margin is 25%. This is what that would look like in practice:
Let’s say an investor deposits $2,000 into a margin account and borrows another $1,000 to invest in financial assets. The portfolio value, in the beginning, would be $3,000, and the equity percentage would be almost 67%. If the value of these assets declines to $2,600 — a 20% decline — the equity value of the account will fall to $1,600 ($2,000 minus the $400 loss), meaning that the equity percentage would stand at 61.5% ($1,600 divided by $2,600).
For the equity percentage to move below the maintenance margin in this particular scenario, the value of the portfolio would have to decline to $1,250 or less. In that case, the investor will receive a margin call and will be prompted by the broker to either deposit more money or partially liquidate the account’s assets to meet the margin requirement.
How to Trade On Margin?
In this section, we will be providing a step-by-step guide on how to trade with margin in case this is your first time doing it.
Step 1: Open and Fund a Margin Account
Most brokerage firms in the United States offer margin trading, as this is an important revenue source for them. For an investor to be eligible to apply for a margin account, they must make a minimum deposit of $2,000. That said, some providers may demand a higher amount.
The application process can typically be completed in a matter of minutes and will require that the investor signs an online agreement that describes the conditions of the margin account, including the applicable interest rates and the dates on which interest payments will be deducted from the account.
This agreement will also describe the instances in which a margin call will be issued and the steps the broker will take to ensure that the percentage of equity in the account remains above the maintenance margin.
Step 2: Determine Your Buying Power
Once the account is opened and funded, investors can check the buying power of their brand new margin account on the trading system. The buying power is typically calculated by dividing the equity value of the account by the initial margin requirement.
As an example, if an investor deposits $20,000 with an initial margin requirement of 50%, this will result in an initial buying power of $40,000. Once a trade is executed, the total value of the trade will be deducted from the buying power.
The buying power increases and decreases based on the equity value of the account. That said, the actual buying power of the account may differ from the one displayed in the broker’s trading system, as some securities may require a higher initial margin for a position to be opened.
Step 3: Make Trade on Margin
Placing a trade order with a margin account works in the same way as doing it with a cash account. The only difference is that the investor will have more money at their disposal to execute the trade.
That said, the system will typically prevent investors from placing a trade if the estimated value of the investment exceeds the account’s buying power.
Step 4: Maintain Your Margin Account
Once the investor has incorporated the first financial assets into the portfolio, it is important to monitor how the value of these instruments fluctuates over time. If there is a sharp decline in the value of some of the assets, it is often a good idea to check the account’s current equity value in relation to the total value of the portfolio.
If the percentage of equity is near the maintenance margin, it would be wise to liquidate a portion of the holdings to reduce the debt, so investors have more room for further declines to avoid a margin call. Another alternative is to deposit more money into the account to raise its equity value.
Understanding a Margin Call
A margin call is a mechanism adopted by brokerage firms and other institutions to protect themselves from any financial damage resulting from the trading losses experienced by their customers. Margin calls are triggered when the equity percentage of an account in relation to the total value of the portfolio declines below a certain threshold.
There are various types of margin calls depending on which minimum requirement has been breached. A Regulation T call occurs if the initial equity provided to open a certain position falls below the minimum required by the Federal Reserve — the US central bank.
Meanwhile, a maintenance call takes place if the percentage of equity in the account, calculated as the value of all holdings (including cash) minus the total debits, drops below the broker’s maintenance margin.
Finally, a minimum equity call occurs if the equity value of the account drops below the minimum margin required by the institution, which is typically $2,000 but could also be higher.
Example of Trading on Margin
The following is an example of how margin trading works in practice by using hypothetical amounts and trades.
Let’s say Mr. Edward opens a margin account with an initial deposit of $10,000.
Mr. Edward acquires shares of several different companies, with the total amount of the trades totaling $30,000 — three times the value of his initial deposit. At this point, the equity value of the account is 33% ($10,000 divided by $30,000).
The brokerage firm requires a minimum maintenance margin of 25%. If the equity value of the account suddenly drops below that percentage, Mr. Edward will face a margin call and will be forced to either deposit more money on the account or liquidate a portion of his holdings.
For the account’s equity value to drop below this percentage, the portfolio would have to decline by 12% or more, at which point the value of the portfolio will be $26,400 while the account’s equity will stand at $6,400 ($10,000 minus the $3,600 loss). In that scenario, the equity percentage would be 24.2%.
If the opposite occurs and the value of Mr. Edward’s holdings within a year rises by 10%, the total gains will be $3,000. The broker charges an annual interest rate of 5% on the margin amount. This means that he will have to pay approximately $1,000 for the loan he took. This means that the net annual profits realized by Mr. Edward would be $2,000.
If he had invested the $10,000 without taking on a margin loan, he would have earned only $1,000. This scenario shows one of the benefits of margin trading, which is that the gains made on a winning portfolio can be increased by borrowing funds from a broker as long as the return earned on that portfolio exceeds the interest rate charged on the loan.
Benefits of Margin Trading (Pros)
- It allows investors to expand their gains without depositing more money into the account by using borrowed funds.
- The interest paid on margin loans is typically tax-deductible.
- Investors gain access to more complex financial instruments such as futures, which require a large amount of funds to be traded. These instruments would be otherwise inaccessible to retail investors without access to a margin account.
- A margin account gives investors the possibility of short-selling. This means borrowing a security from the broker to sell it with the expectation that its price will decline. If that happens, the trader will get to buy back the security at a lower price in the future while keeping the difference.
- Most brokers allow investors to withdraw a portion of their margin loan despite having most or all of their equity invested. As long as the equity percentage exceeds the maintenance margin, the account will not be subject to a margin call.
- The interest rate charged on margin loans could be very attractive compared to other credit instruments such as credit cards and payday loans.
Downsides of Margin Trading (Cons)
- Investors may incur losses that exceed the value of their initial deposit if their portfolio experiences losses that surpass the amount of equity within the account.
- The minimum amount required by some financial firms to allow investors to trade on margin can be high.
- The interest paid on the margin loan will increase an investor’s losses or eat up a large portion of the portfolio’s gains if the return earned on the investments does not exceed the interest rate charged on this loan.
- A broker may force the investor to liquidate some of their holdings at a loss.
FAQs on Margin Trading
We’ve found some of the most frequently asked questions about margin trading, and here are our answers.
What Is Margin?
In finance, the word margin refers to the equity an investor pledges to access borrowed funds that can be used to purchase financial securities.
What Is A Margin Rate?
The margin rate is the interest rate charged by a brokerage firm on the funds an investor borrows on margin. This rate is typically comprised of two elements: a base rate and an additional percentage that varies depending on the size of the loan. The higher the amount borrowed, the lower this additional percentage typically is.
How Much Money Do You Need to Trade on Margin?
As per U.S. regulations, the minimum margin required to open a margin account is $2,000. However, some brokerage firms may opt to require a higher amount.
What Assets Can Be Traded on Margin?
In the context of margin trading, securities are classified as marginable and non-marginable. Marginable securities are those that can be bought by using borrowed funds. Most stocks, exchange-traded funds (ETFs), and mutual funds are marginable. Penny stocks may also be marginable depending on their volatility. However, the initial margin required may be higher than regular stocks and ETFs.
Non-marginable securities are typically those that carry a high risk or are considered highly volatile. These include penny stocks, over-the-counter (OTC) securities, and, in some cases, options.
Is Margin Trading Good for Beginners?
Beginners should trade on margin wisely, as using borrowed funds to operate in the markets can lead to losses that exceed the initial amount deposited on the trading account.
Even though one of the benefits of margin trading is that it expands an investor’s gains, it can also increase the losses resulting from a bad-performing trade. Beginners should only trade on margin if they fully understand the risks involved and have a well-conceived trading strategy.
What Account Types Are Available for Margin Trading?
In most cases, only taxable accounts are permitted to trade on margin as the Internal Revenue Service (IRS) prohibits the use of assets held within a retirement account as collateral. However, some brokers offer limited margin features.
What Is the Primary Use of Margin Trading?
Margin trading is typically used to increase the gains produced by a certain investment as it increases the size of a given position to the point that the investor can cover the borrowing cost and keep the rest.
Can I Trade IPOs on Margin?
Most initial public offerings (IPOs) cannot be bought on margin within the first 30 days after the stock is listed on the exchange. The reason for this is that the brokerage firm does not have enough data to assess the volatility of the instrument, and that exposes them to an above-average level of risk.
Are Bonds and Debt Securities Available to Trade on Margin?
Yes. Bonds and other fixed-income securities can typically be traded on margin. However, the initial margin required on these trades may be different than the baseline of 25%, depending on how volatile the instrument is.
Margin trading is an activity that involves using borrowed funds from a broker to place trades. These funds can be used to increase the gains resulting from such transactions, but losses can also be enlarged if the trade does not perform as expected.
We hope that, after reading this article, you have gained a deeper understanding of how margin trading works so you can decide if this is a strategy that fits your risk tolerance and financial goals at the moment.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.