Trading on margin is similar to a loan from a bank; only you are borrowing funds from your brokerage firm to purchase stock. Trading on margin allows a trader to purchase stock with less funds than with a regular trading account. It is necessary to obtain approval to open a margin trading account, and there is usually a minimum balance required. The minimum can vary by broker. Options are not eligible for margin trading in a regular (Reg-T) margin account.
Once a margin account is approved and opened, a trader can “borrow” up to 50% of the purchase price of a stock. Not all stocks qualify for margin trading. For example, penny stocks and initial public offerings (IPOs) are not marginable because of the high risk involved with these types of stocks.
Just like a loan from a bank, trading on margin has costs associated with it. You can keep your “loan” as long as you fulfill your obligations. Stocks that you purchase on margin are collateral, and there will be interest charged on the loan. When you purchase stock in a margin account, as you sell shares the proceeds for the sale go to your broker to repay the loan until it is paid in full.
There is “maintenance margin” associated with a margin account, which is the minimum account balance you must maintain in the account. If the account balance drops below this minimum, you will receive what is called a “margin call” from your broker. A margin call will require you to deposit additional funds, or sell some of stock, in order to bring the account balance above the minimum.
If for any reason you are not able to meet a margin call, the brokerage firm has the right to liquidate stock positions as necessary in order to bring the account balance above their minimum. A rather unsettling thought is that some margin agreements state that the broker is not required to notify you before liquidating some of your stock holdings, which may result in the sale of stock from your account without your knowledge. It is critical that if you are planning on trading stocks on margin, you read and understand thoroughly your broker's margin agreement very carefully.
What are the advantages of trading on margin?
The best way to show the advantages of trading on margin is with an example. Let's say that you deposit $5,000 into a margin account, which gives you stock buying power of $10,000. As a margin account holder, you can purchase 100 shares of ABC Company stock currently trading at $100 totaling $10,000 – using $5,000 of margin and $5,000 cash.
ABC Company's stock jumps to $150 per share on a new product release, and you sell your 100 shares for $150 totaling $15,000. After paying back your broker the loan of $5,000, you have made back your initial cash purchase of $5,000, plus a profit of $5,000. This example may be a bit extreme, but you can see how the leverage of being able to purchase stock on margin can be appealing.
There are risks of trading on margin.
To illustrate the risks of buying stocks on margin, let's use the same example of ABC Company. Instead of the 50% increase in the stock after the new product announcement, ABC Company's stock drops 25% to $75 per share. The value of the 100 shares you purchased is now only $7,500. You do not see a rebound in sight, and sell your 100 shares for $75 per share totaling $7,500. After paying your broker back the loan of $5,000, you now only have $2,500 of your initial $5,000 investment. That equals a 50% loss, plus commissions and interest. The loss would have only been 25% if you had only used cash to purchase the stock.
Buying stocks on margin is not for everyone; it can act as a double edge sword. As the two examples illustrate, profitable stock transactions can be amplified, but those that are losers can also hurt to a larger degree than just using a cash account. Whether or not you choose to use margin in your stock trading, remember that you do not have to go up to the maximum 50% borrowing level, and never risk more than you can afford to lose.
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