When purchasing something like a car or a house, most people don’t have the lump sum of cash sitting around to buy it outright, so they borrow money to finance it. These borrowing rates vary depending on your credit score and the amount you’re borrowing, but usually, the buyer and seller can come to an agreement.
Many investors also borrow money to buy stocks in order to increase profits. For example, let’s say you have $10,000 available for trading right now and borrow $5,000 more from your broker. You invest all $15,000 in a stock that gains 20% in a month. Your profits are $3000 and after the trade, you return the borrowed $5000 to the broker. You have $13,000 in your account now instead of $12,000 thanks to the loan from the broker.
When you borrow money from your broker, it’s called margin and you can imagine there’s certain risks involved when trading borrowed money. When using margin, a bad trade can turn into a nightmare scenario if the broker comes calling for their cash back before you can recover. Only experienced traders should buy stocks with borrowed money. Here are a few things to take note of before opening a margin account.
What is Margin?
Margin is just broker-speak for borrowed money. Just like taking out a loan from a bank, your broker can lend you money to buy stocks. But not for free, of course. Just like any other loan, the broker will charge an interest rate that must be periodically paid. Margin rates vary depending on the broker you use and how much money you wish to borrow.
When borrowing money from your broker, you’ll need to have a certain amount in the account first. No broker is going to lend money to a client if their account balance is close to zero. Most brokers have a maximum of 50%, meaning you need $2 in your account for every $1 you borrow. Margin loans can increase your profits since you’ll possess more stock than your principal balance would allow, but it can also exacerbate losses and force broker-initiated liquidations.
How Do You “Buy on Margin?”
Buying on margin simply means buying stocks with borrowed money. But you can’t just ask your broker for extra cash, you’ll need to open an account specifically designed for margin trading. Margin accounts have specific requirements that must be met – more on those later.
When you buy on margin, you’ll first need to identify a stock you want to buy. Are you looking for short-term profits or long-term wealth appreciation? You’ll need to approach the trade a little differently than usual since you must factor in the interest on the margin loan, especially if you plan on holding shares with borrowed money for an extended period of time. Make sure to fully understand the terms and conditions of the margin loan too. You don’t want to be blind sided by rules or clauses you’re not aware of.
Initial Margin vs. Maintenance Margin
Traders can’t just borrow thousands and thousands of dollars from the broker without a little skin in the game themselves. Margin requirements refer to how much of their own cash a trader must keep in the account in order to maintain a position or avoid the dreaded margin call.
Initial margin is the amount you’ll need in cash in order to open (or initiate) a position on margin. Initial margin will vary depending on the security and/or broker, but a common number is 50%. With a 50% initial margin requirement, you’ll need to pony up at least half the cash required to execute your trade. For example, if you have $2000 in your account and purchase a stock with a 50% initial margin requirement, you can buy $4000 worth of shares.
Maintenance margin comes into play after you’ve executed your trade and are holding your position. Brokers won’t allow you to hold on to a losing trade in perpetuity and will eventually ask for their money back if the value of your account drops too low. Maintenance margin is the amount of equity you control with your own cash – the amount of your own capital required to ‘maintain’ your position.
Using our previous example, you needed 50% of the cash upfront in order to meet the initial margin requirement, but you may only need 25% in order to hit the maintenance margin requirement. Again, this number can vary depending on the security and broker, but the maintenance margin MUST be met in order to avoid a margin call. If your $4000 position drops below $3000, you’ll be controlling less than 25% of the shares with your own capital and the broker may issue a margin call. To avoid a margin call, you’ll need to either sell stock or deposit more money into your account.
What is a Margin Trading Account?
To trade on margin, you’ll need to open a margin trading account. You’ll need to fill our specific paperwork to request the margin account, which has different rules than your standard cash account. A broker cannot offer you margin unless you specifically ask for it, but the process is usually painless. Here are the pros and cons of using margin accounts.
Advantages of Margin Accounts
- Increased profits – The biggest benefit of using margin is you can increase your gains without committing more of your own capital to your trades. Using borrowed money can help you build your wealth more quickly than if you stuck to the traditional cash accounts.
- Can use cash or margin – With a margin account, you don’t have to borrow money. Sure, it’s a nice option to have and utilize, but you can open a margin account and trade with only your own cash if you wish. And even if you do borrow money, you don’t need to take the full initial margin. There’s no crime in only borrowing 25% of the funds needed to purchase a stock with 50% initial margin.
- No Good Faith Violations – When using a cash account, you must wait for funds from a stock sale to settle before using them to purchase another security, otherwise you risk being tagged with a Good Faith Violation (GFV). Too many GFVs can have your account restricted, a fear you won’t need to have when using a margin account.
Disadvantages of Margin Accounts
- Minimum balance requirements – You’ll need at least $2000 to open a margin account at a broker, and the key words here are ‘at least’. Most cash accounts now have no minimum and you only need the price of a single share to make a trade. Not so with margin accounts.
- Surrendering some control – Using borrowed money means giving up a little bit of control over your positions. You’ll need to pay interest on the loan and you may need to sell shares before you really want to.
- Potential for forced liquidations – If your trade really turns bad, you may not have a chance to wait for a rebound. In fact, your broker might issue a margin call if you drop below maintenance margin requirements, which could result in forced liquidations. And guess what, your broker doesn’t even need to tell you they’re liquidating your positions! They can sell whichever shares they choose in order to recoup the money they’ve lent too.
Risk of Margin Trading
Margin trading involves using leverage and every great investor blow-up story usually involves some type of leverage. Even though most brokers will only allow you to borrow 50%, you’re still using the shares in your account as collateral. You’re not only surrendering control, but you’re putting yourself at risk to potentially lose more than your initial investment.
Let’s say your $4000 position on 50% margin suffers a meltdown due to something unforeseen, like fraud or a drug trial failure. You’ve got $2000 of your own money in the trade, but the stock loses 75% and your position is now worth $1000. You still owe $2000 to your broker which means you’ve not only lost your initial investment, but you’re $1000 in the red. If you don’t square up with your broker, they can liquidate other securities in your account in order to rectify your obligations.
Final Thoughts
When used carefully, margin trading can increase the value of your account at a faster pace than the capital you have on hand would allow. Using margin responsibly on dependable stocks can be a great way to increase your wealth without needing to take extra cash away from other areas of your finances.
However, margin trading isn’t for market newcomers as risks must be carefully calculated and you’ll need to act quickly if a trade turns against you. Traders who don’t understand the risks and benefits of margin can quickly find themselves digging out of a hole. Remember, compound interest works both ways. Borrowed money can be a terrific asset when used on a winning trade, but a wealth annihilator when applied to a losing one.
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