Home » Margin and Margin Trading Explained Plus Advantages and Disadvantages

Margin and Margin Trading Explained Plus Advantages and Disadvantages

« Back to Glossary Index

In finance, the margin is the collateral that an investor has to deposit with their broker or exchange to cover the credit risk the holder poses for the broker or the exchange. An investor can create credit risk if they borrow cash from the broker to buy financial instruments, borrow financial instruments to sell them short, or enter into a derivative contract.

Buying on margin occurs when an investor buys an asset by borrowing the balance from a broker. Buying on margin refers to the initial payment made to the broker for the asset; the investor uses the marginable securities in their brokerage account as collateral. 

In a general business context, the margin is the difference between a product or service’s selling price and the cost of production, or the ratio of profit to revenue. Margin can also refer to the portion of the interest rate on an adjustable-rate mortgage (ARM) added to the adjustment-index rate.

Understanding Margin and Margin Trading

Margin refers to the amount of equity an investor has in their brokerage account. “To margin” or “buying 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. A margin account is a brokerage account in which the broker lends the investor money to buy more securities than what they could otherwise buy with the balance in their account.

Using margin to purchase securities is effectively like using the current cash or securities already in your account as collateral for a loan. The collateralized loan comes with a periodic interest rate that must be paid. The investor is using borrowed money, and therefore both the losses and gains will be magnified as a result. Margin investing can be advantageous in cases where the investor anticipates earning a higher rate of return on the investment than what they are paying in interest on the loan.

For example, if you have an initial margin requirement of 60% for your margin account, and you want to purchase $10,000 worth of securities, then your margin would be $6,000, and you could borrow the rest from the broker.

Buying on Margin

Buying on margin is borrowing money from a broker in order 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. This is different from a regular cash account, in which you trade using the money in the account.

Minimum Margin

By law, your broker is required to obtain your consent to open a margin account. The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin.

Initial Margin

Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It’s essential to know that you don’t have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.

You can keep your loan as long as you want, provided you fulfill your obligations such as paying interest on time on the borrowed funds. When you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid.

Advantages and Disadvantages of Margin Trading

Advantages of Margin Trading

The primary reason investors margin trade is to capitalize on leverage. Margin trading centers increase purchasing power by increasing the capital available to purchase securities. Instead of buying securities with money they own, investors can have to buy more securities using their capital as collateral for loans greater than their capital on hand.

For this reason, margin trading can amply profits. Again, with more securities in hand, increases in value have greater consequential outcomes because you’re more heavily invested using debt. On the same note, if the value of the securities posted as collateral also increases, you may be able to further utilize leverage as your collateral basis has increased.

Margin trading is also usually more flexible than other types of loans. There may not be a fixed repayment schedule, and your broker’s maintenance margin requirements may be simple or automated. For most margin accounts, the loan is open until the securities are sold during which final payments are often due to the borrower.

Disadvantages of Margin

If investors primarily enter into margin trading to amply gains, they must be aware that margin trading amplifies losses. Should the value of securities bought on margin rapidly decline in value, an investor may owe not only their initial equity investment but owe additional capital to lenders. Margin trading also comes at a cost; brokers often charge interest expenses, and these fees are assessed regardless of how well (or poorly) your margin account is performing.

Because there are margin and equity requirements, investors may face a margin call. This is a requirement from the broker to deposit additional funds into their margin account due to the decrease in the equity value of securities being held. Investors must be mindful of needing this additional capital on hand to satisfy the margin call.

Should investors not be able to contribute additional equity or if the value of an account drops so fast and breaches certain margin requirements, a forced liquidation may occur. This forced liquidation will sell the securities purchased on margin and may result in losses to satisfy the broker requirement.

Margin Trading

Advantages

  • This may result in greater gains due to leverage
  • Increases purchasing power
  • Often has more flexibility than other types of loans
  • Maybe a self-fulfilling opportunity cycle where increases in collateral value further increase leverage opportunities

Disadvantages

  • This may result in greater losses due to leverage
  • Incurs account fees and interest charges
  • This may result in margin calls that require additional equity investments
  • May result in forced liquidations which result in the sale of securities (often at a loss)

Example of Margin

Let’s say that you deposit $10,000 in your margin account. Because you put up 50% of the purchase price, this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and haven’t tapped into your margin. You start borrowing the money only when you buy securities worth more than $10,000. 

Note that the buying power of a margin account changes daily depending on the price movement of the marginable securities in the account.

Other Uses of Margin

Accounting Margin

In business accounting, margin refers to the difference between revenue and expenses, where businesses typically track their gross profit margins, operating margins, and net profit margins. The gross profit margin measures the relationship between a company’s revenues and the cost of goods sold (COGS). Operating profit margin takes into account COGS and operating expenses and compares them with revenue, and net profit margin takes all these expenses, taxes, and interest into account.

Margin in Mortgage Lending

Adjustable-rate mortgages (ARM) offer a fixed interest rate for an introductory period of time, and then the rate adjusts. To determine the new rate, the bank adds a margin to an established index. In most cases, the margin stays the same throughout the life of the loan, but the index rate changes. To understand this more clearly, imagine a mortgage with an adjustable rate that has a margin of 4% and is indexed to the Treasury Index. If the Treasury Index is 6%, the interest rate on the mortgage is the 6% index rate plus the 4% margin, or 10%.45

What Does It Mean to Trade on Margin?

Trading on margin means borrowing money from a brokerage firm in order to carry out trades. When trading on margin, investors first deposit cash that then serves as collateral for the loan and then pay ongoing interest payments on the money they borrow. This loan increases the buying power of investors, allowing them to buy a larger quantity of securities. The securities purchased automatically serve as collateral for the margin loan.