When I first started investing in stocks, I found information on my brokerage’s website about margin accounts. From what it sounded like, I could borrow money from my brokerage in order to buy stock I couldn’t afford with the hopes that it would rise in value…
I didn’t like the look of that so I steered clear. Years later, I’ve used margin on a couple occasions but never as a common practice and only when I’ve calculated the risk well in advance.
I want to show you what I’ve learned about Margin by covering the advantages and disadvantages of trading on margin so you can decide for yourself if it has a place in your investing strategy.
What is Margin Trading?
Trading on Margin is simply the act of borrowing money from your brokerage in order to buy stock. In order to borrow money on margin, you must first have a margin account which can be setup with most brokerages.
The best way to illustrate how Margin works is to use an example:
Let’s say you want to invest in company Death Star. Death Star has a stock price of $100/share. You have $2000 that you want to invest which means you can buy 20 shares (assuming you pay $0 in commissions).
If you had a margin account and borrowed 25%, you would be purchasing shares of Death Star at 75% Margin which means 75% with your money and 25% of borrowed money. This means you could still get your 20 shares but will only need to pay out $1500 (75%) and borrow $500 (25%).
If the stock goes up to $150/share, it will be worth $3000. How much did you make? Since the stock went up $50/share, the investment made $1000 ($50 x 20). Whether you invested the full $2000 or only invested $1500 with Margin, the amount gained is the same. The difference is that you were able to make that $1000 with less money so by using margin, you made a larger return on your invested capital.
|Invested Capital||Margin||Total Invested||Performance (Profit)||Return on Invested Capital|
|$2000||100% Equity (no margin)||$2000||$1000||50%|
The thing to remember is that since you borrowed money from your brokerage, you will need to pay that borrowed money back when the trade is closed with interest!
How much interest? That all depends on the Margin Rates set by your individual brokerage.
Every brokerage is different but here’s the Margin Rates for Webull:
How Much Can I Borrow on Margin?
The Federal Reserve Board sets Margin Limits. According to FINRA the current minimum margin amount is 50% which means that you need to have at least 50% of the market value in equity in order to take out Margin.
In the example of company Death Star, you would need to at least invest $1000 in order to borrow 50% ($1000) from the brokerage to buy a $2000 position.
What’s a Margin Maintenance Requirement?
Since there is an initial requirement of 50% margin to place a trade on margin, the brokerage needs to protect itself in the event that the position goes against you. The Federal Reserve Board also put in a place a Maintenance Requirement of 25%.
What this means is that your equity in the position must stay above 25% or else you will receive a Margin Call.
What’s a Margin Call you ask? It means the brokerage sends you a notice that you are below the maintenance requirement and you will need to deposit funds to raise the equity above 25%.
Let’s look at company Death Star again and say it dropped in value to $75/share.
|Equity Invested||Margin||Total Invested||Performance Lost||Equity Value|
|$2000||100% ($0)||$2000||-$500||75% (No Margin)|
|$1500||75% ($500)||$2000||-$500||67% Margin|
|$1000||50% ($1000)||$2000||-$500||33% Margin|
As you see in the first example, an investor would only have lost 25% and if that investor is investing long term, can ride out the storm until it hopefully rebounds and becomes profitable.
In the last example, as Margin approaches 25%, the risk of a margin call becomes greater and an investor may need to choose to close the trade and cover the loss earlier than anticipated.
How to Calculate Margin
Margin = (Value of Security – Debt Balance)/Value of Security
Margin = (V-D)/V
So if the value of your shares of Death Star were $1500 and you borrowed $500:
Margin = ($1500-$500)/$1500 = 67%
Advantages of Trading on Margin
I know I’ve painted this a little gloomy with the Death Star and all; however, there are advantages. Advantages to Trading on Margin include:
- Enables you to invest in opportunities that you may not be able to afford due to tied up funds (such as other investments)
- Allows you to invest in a larger position for the same amount of capital
- Ideal for short term trades since it allows you to use borrowed money at low interest to take advantage of timely purchases
- Allows you to keep more money on the side for opportunities while still allowing you to participate in the trade at hand
- For shorting stock, a margin account is required.
Disadvantages of Trading on Margin
- There is the risk of losing more money than you originally invested
- Margin calls may force you to invest more money or sell off other stock to cover a bad trade
- Margin calls may force you to terminate a trade earlier than you anticipated.
- Trading on margin requires a minimum balance to be maintained.
- Margin fees stack up the longer you maintain the position on margin
- If a trade goes south, you lose your own capital and still owe the borrowed amount back.
Real Life Example of Using Margin
I actually have an active trade on margin currently:
Disclaimer: By telling you this, I am by no means encouraging you to invest in the same company that I have invested in. Do you own research to determine what companies belong in your portfolio
I purchased 10 shares of Boeing for $1837.50 and borrowed $550.22 on margin. I wanted to buy 10 shares but couldn’t afford all 10 because the rest of the money in my brokerage account was already invested.
Let’s calculate the margin:
M=(V-D)/V = ($1837.50 – $550.22)/$1837.50/($1837.50) = 70% Margin.
Today, it has dropped in value to $1700 for an unrealized loss of almost 7.5%.
By recalculating, we get M = ($1700-$550.22)/$1700 = 67.6%
My margin has only reduced 3.4% but it swung down much lower than that previously to about 58% Margin and has since recovered. The downside though is that although I’m not down very much in my position, I’ve been in this trade a little longer than I anticipated.
I’m planning on adding more funds to cover the margin and I plan to keep this position for a minimum of five years.
Margin trading is not for the feint of heart. Only use margin if you have a strategy in place to manage the risk and time-horizon of the trade. If you are a passive investor and looking for long term portfolio growth, margin is not the correct application for you.
Always have a plan when using margin and an exit strategy in place for if the trade goes against you.
If you are looking for more information on getting started investing, check out our intro article on how to invest in stocks.
Do you disagree with anything written here or have another pro or con for using margin? Share it below!
Until next time, let’s start investing.