At Fidelity, for example, the interest rate you’ll pay on margin balances up to $24,999 is 8.325%. When you compare that rate to the 9% to 10% potential annual return in stocks, you’ll quickly recognize that you’re taking the risk, but the broker is getting much of the rewards. Because of interest, when you use margin you have to worry about your net profit margin, or your profits after paying interest, which will be less than your investing gains. At that point an investor has from a few hours to a few days to bring the account value up to the minimum maintenance level. She can do that by depositing more cash or selling equities (or closing option positions) to increase the amount of cash in the account. Margin trading, or “buying on margin,” means borrowing money from your brokerage company, and using that money to buy stocks.
Investments in retirement accounts or custodial accounts aren’t eligible. To buy stocks on margin, a margin account must be opened and approval obtained for the loan. If the stock’s price rises, the investor can sell the stock, repay the loan, and keep the profit. If the stock’s price falls, the broker may issue a margin call, requiring more cash or selling the stock.
In other words, if a broker lent 50% of the purchase price, you must deposit the other 50%. However, some brokerage firms may require more than 50% of the purchase price for the initial trade. The investor can deposit cash or sell securities purchased with borrowed money. If the investor does not comply, the broker may liquidate the investor’s collateral to restore the maintenance margin. In addition, the equity in your account has to maintain a certain value, called the maintenance margin.
When a margin call is issued, you will receive a notification via the Secure Message Center in the affected account. There are several types of margin calls and each one requires a specific action. Returning to the example above, let’s say that your broker’s maintenance margin requirement is 40% versus the 25% FINRA requirement. After paying your broker the $10,000 owed for the loan, your cash balance is now $5,000.
In this scenario, the total margin requirement for the short straddle is $8650. This is derived by taking the margin requirement for the naked calls (the greater requirement) and adding to it the current value of the puts. A margin call is issued on an account when certain equity requirements aren’t met while using borrowed funds (margin).
In Scenario 1, the margin requirement would be $9000 as it is the highest requirement of the 3 examples. The following account is in a Regulation-T call in the amount of $2,000 and is looking to get back to positive by selling a stock in the account. When using leverage, it’s possible to lose more than your initial investment.
The total amount you can deploy using margin is known as your buying power, which in this case amounts to $10,000. (Schwab clients may check their buying power by clicking on the “Buying Power” link at the top of the Trade page on Schwab.com). Just as you doubled your gains in scenario one when the stock price increased, you doubled your losses in scenario two when the stock price declined.
“If you’re in front of your terminal every day, you have strict loss limits and you have a trader mentality, margin investing can be a great thing in up markets. But investors should only do it when the market is going to keep going up and have very strict loss limits,” says Watts. The client decides not to purchase ABC, but would rather own XYZ which has a 40% margin requirement. As an investor, you have no control over the timing of a margin call, and you can fall victim to one even if it’s just from a short-term movement.
What does Buying on Margin Mean?
Even if you still believe that a stock will recover, and it does, you could still be forced to liquidate, meaning you missed out on gains you would have gotten if you were using an ordinary cash account. Miss the margin call deadline, and the broker will decide which stocks or other investments to liquidate to bring the account in line. Imagine again that you used $5,000 cash to buy 100 shares of a $50 stock, but this time imagine that it sinks to $30 over the ensuing year.
Stock values are constantly fluctuating, putting investors in danger of falling below the maintenance level. As an added risk, a brokerage firm can raise the maintenance requirement at any time without having to provide much notice, according to the fine print of most margin loan agreements. Each brokerage firm can define, within certain guidelines, which stocks, bonds, and mutual funds are marginable. The list usually includes securities traded on the major U.S. stock exchanges that sell for at least $5 per share, though certain high-risk securities may be excluded.
As an example, a client with $10,000 of cash in a margin account would be able to purchase up to $20,000 worth of marginable securities, this is known as a client’s Stock Buying Power. When you have a margin loan outstanding, your broker may issue something known as a margin call, particularly if the market moves against you. When you get a margin call, your broker can demand you pony up more cash or sell out positions you currently own in order to satisfy the call.
In essence, the practice allows investors to increase their portfolio beyond the size of their real available funds. 2 At Schwab, margin accounts generally receive a maintenance call when equity falls below the minimum “house” maintenance requirement. As with any loan, when you buy securities on margin you have to pay back the money you borrow plus interest, which varies by brokerage firm and the amount of the loan. Additionally, the broker may issue a margin call, which requires you to liquidate your position in a stock or front more capital to keep your investment. In addition to risks, traders must also pay additional fees for their margin positions.
After you make the purchase, you own $20,000 in stock, owe the broker $10,000, and the value of the stock serves as collateral for the loan. Outlined below shows the scenario had the stock’s price increased in value. While margin traders can make higher profits, they can also incur larger losses. It is even possible for a margin trader to lose more money than they originally had to invest—meaning that they would have to make up the difference with additional assets. In the above example, the client’s account value is $5250, but the client owns $10,764.81 worth of securities. The difference between these numbers (-$5514.81) is the amount the client is borrowing on margin.
Why Is Buying on Margin Risky?
Trading foreign exchange on margin carries a high level of risk, as well as its own unique risk factors. Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Prior to trading options, you should carefully read Characteristics and Risks of Standardized Options.
- While margin traders can make higher profits, they can also incur larger losses.
- If the stock’s price rises, the investor can sell the stock, repay the loan, and keep the profit.
- The simple definition of margin is investing with money borrowed from your broker.
- That amounts to a total loss of $4,000 (her original $3,000 investment plus an additional $1,000 to satisfy the terms of the loan).
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Initial Margin
Remember that it’s beneficial to your broker for you to use a margin account since it’s an easy way for them to make money, so it’s in their interest to encourage you to do so. A margin account permits investors to borrow funds from their brokerage firm to purchase marginable securities on credit and to borrow against marginable securities already in the account. Interest is charged on the borrowed funds for the period of time that the loan is outstanding. A pattern day trader’s account must maintain a day trading minimum equity of $25,000 on any day on which day trading occurs.
Short selling means borrowing shares from your brokerage with the intent of buying them back at a lower price. That strategy works when the share price falls, but it can easily backfire. If the stock goes up, you lose money, and, unlike owning a stock, your losses are theoretically unlimited. If your broker starts selling out your positions, that broker doesn’t care about your tax situation, your view of the company’s long-term prospects, or anything else other than satisfying the call.
So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 for a gain of 72%.
Benefits and risks of margin buying
The loan must be repaid regardless of whether the stock rises or falls. Before initiating the first trade on margin, the Federal Reserve limits how much can be borrowed on margin for the initial trade—called the initial margin. A brokerage firm can lend a customer up to 50% of the total purchase price of a stock for a new purchase.
We believe everyone should be able to make financial decisions with confidence. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone.