Download the Schwab app from iTunes®Get the AppClose

  • Find a branch
To expand the menu panel use the down arrow key. Use Tab to navigate through submenu items.

Risks and Rewards of Margin Trading

Risks and Rewards of Margin Trading

Key Points
  • Margin trading enables you to borrow money against securities in your account, which can be used as collateral against new positions.

  • Margin accounts are required to maintain a minimum level of equity.

  • Margin trading can potentially enhance your profits or magnify your losses.

The double-edged sword of leverage

Margin trading is an account feature that allows you to borrow against the securities you hold in your brokerage account, pledging them as collateral against new positions. Margin trading has the potential to either magnify your profits, or magnify your losses.

Because this type of trading involves borrowing money, you will incur interest charges. There are two sides to this, and on the plus side, there is generally no set repayment schedule for a margin loan, as long as you maintain the required minimum level of equity. Additionally, in the short term, the additional profits on winning trades could outweigh the interest charges.

We will talk more about this below. 

On the downside, however, keeping a debit balance in your account for long periods of time can result in sizable margin interest charges. And on losing trades, interest charges will also increase your total losses.

Here's a comparison of trading in a cash account versus a margin account.

Benefits of trading in a cash account

  • Securities are paid for in full.
  • Your potential loss is limited only to the amount invested.
  • You own your securities until you decide to sell them.
  • You won’t be forced to sell your shares during unfavorable market conditions.

Risks of trading in a cash account

  • Generating cash for other opportunities may trigger capital gains obligations.
  • Successful cash investments will usually result in lower overall profits than leveraged investments.
  • You may have to pass on investment opportunities that are just slightly more expensive than your investable cash.

Benefits of trading in a margin account

  • The leverage allows you the ability to buy up to twice as many shares as in a cash account.
  • You have the flexibility to take advantage of short-term market opportunities.
  • You can maintain your core holdings and potentially defer any capital gains taxes that might result from selling securities to meet your short-term trading needs.
  • If you hold a concentrated stock position, margin trading may help you diversify your portfolio.
  • Margin interest is often tax-deductible against your investment income.

Risks of trading in a margin account

  • Margin can magnify gains but it also magnifies losses.
  • Margin accounts are more sensitive than cash accounts to day-to-day market moves.
  • With margin trading, you can lose more funds than you have in your account.

Maintaining a level of equity

You should keep a couple of things in mind for margin accounts. The amount you can initially borrow on margin is typically limited to 50% of the value of the marginable securities in your account. And if your securities should start to decline in value, you are always required to maintain a minimum level of equity (currently 30% at Schwab for most equities).

If you fall below this, you may be required to deposit additional money (or marginable securities) into the account to increase your account equity immediately. Also, if you are either unable or unwilling to do so, Schwab will close out positions in your account to increase the account equity back to this minimum maintenance level.

Should your positions lose value quickly, and your margin loan balance exceed the proceeds from the closed-out securities, you could end up not owning any securities, but still owing money.

While the amount you can initially borrow on margin is typically limited to 50% of the value of the marginable securities in your account, you may want to borrow less if your personal risk tolerance is low, or your account is primarily composed of high-volatility securities. Although a broadly diversified portfolio with a smaller debit balance would typically have to decline significantly to trigger a maintenance call, a prudent approach is to resist the temptation of using all of the credit available to you.

Whether your trades are profitable or not, you will always have to pay back the total dollar amount you borrowed plus margin interest charges, which are compounded daily and posted monthly. No matter how much the stocks you buy increase in price, your margin debit will still have to be paid back, but if the value of the stock drops far enough, you could end up owing more than the amount you initially borrowed. 

Margin trading can magnify gains

The comparison below illustrates a hypothetical investment of $100,000 over a 12-month period in a cash account versus a margin account.

In Example 1, assume you have $100,000 to invest and you borrow an additional $25,000 so you can purchase $125,000 in stock. If the stock increases in value by 25% ($125,000 x 25%), the year-end gross value will be $156,250. Then, if you pay the interest expense ($2,167) plus the amount you borrowed ($25,000), your year-end net value would be $129,083.

Using margin increased your annual return to 29% ($29,083/ $100,000) versus 25% ($25,000/ $100,000) if you had traded on a cash basis only.

Example of how margin can magnify gains

Example 1:

Cash account

Margin account

Account balance

$100,000

$100,000

Borrowed on margin

$0

$25,000

Securities' net return

25%

25%

Year-end gross value

$125,000

$156,250

Interest expense1

$0

($2,167)

Payoff margin loan

$0

($25,000)

Year-end net value

$125,000

$129,083

Total annual return

25%

29%

 

Margin trading can magnify losses

In Example 2, assume you have $100,000 to invest and you borrow an additional $25,000 on margin, purchasing $125,000 in stock. If the stock decreases in value by 25%, the year-end gross value will be $93,750. After paying the interest expense ($2,167) and the amount you borrowed ($25,000), your year-end net value would be only $66,583.

Using margin increased your annual loss to -33% ($33,417/ $100,000) versus -25% ($25,000/ $100,000) if you had traded on a cash basis only.

Example of how margin can magnify losses

Example 2:

Cash account

Margin account

Account balance

$100,000

$100,000

Borrowed on margin

$0

$25,000

Securities' net return

-25%

-25%

Year-end gross value

$75,000

$93,750

Interest expense1

$0

($2,167)

Payoff margin loan

$0

($25,000)

Year-end net value

$75,000

$66,583

Total annual return

-25%

-33%

 

Source: Schwab Center for Financial Research.

Investing always involves some level of risk and margin trading is no exception. Before you trade on margin, it is important to think about how margin trading fits into your overall trading strategy. Margin trading is not right for everyone because it requires a higher level of risk tolerance than trading on a cash basis. Just be sure you understand the risks, before you risk your own money.

For more information about trading on margin, please visit schwab.com/margin; or call a Schwab trading specialist.

I hope this enhanced your understanding of margin trading. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Long Butterfly Spreads: Understanding the Basics
Long Butterfly Spreads: Understanding the Basics
How Do You Define Risk?
How Do You Define Risk?

Schwab has tools to help you mentally prepare for trading

Learn more >

Talk trading with a Schwab specialist anytime.
 
Call 888-245-6864
M-F, 8:30am - 9:00pm EST

Get 500 Commission-Free Online Equity and Options Trades for Two Years

Learn More >

(0814-4903)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.