Many investors are familiar with margin or margin trading but may be fuzzy on exactly what it is and how it works. That's understandable because margin rules differ across asset classes, brokerages, and exchanges.
For example, trading stocks on margin—under Regulation T, or "Reg T"—is quite different from portfolio margin or trading futures and forex, which also creates leverage. However, the underlying premise is the same: Margin creates leverage through either borrowing money or putting up less of your own funds for a trade. Leverage is aimed at magnifying gains but also creates the possibility for significant losses.
Here are a few basic questions and answers about margin trading.
What are the benefits of margin trading?
You get more bang for your trading buck—or at least, that's the idea. With margin trading, you're only required to deposit a percentage of the notional value of a given security, which can increase your buying power. Margin provides leverage that could enhance returns. Through margin, you put up less than the full cost of a trade, potentially enabling you to take larger trades than you could with the actual funds in your account.
How does margin trading work?
Margin trading typically requires submitting an application and posting collateral with your broker, and you must pay margin interest on money borrowed. Margin interest rates vary among brokerages. In many cases, securities in your account can act as collateral for the margin loan. (A Charles Schwab account that's approved for margin trading must have at least $2,000 in cash equity or eligible securities and a minimum of 30% of its total value as equity at all times.)
What do I need to know about Reg T and other margin rules?
Under Reg T, a Federal Reserve Board rule, you can borrow up to 50% of the purchase price of securities that can be purchased on margin, also known as initial margin. Some brokerages require a deposit greater than 50% of the purchase price.
Exchanges and self-regulatory organizations, such as FINRA, have their own margin trading rules, and brokerages can establish their own margin requirements, as long as they are at least as restrictive as Reg T, according to the U.S. Securities and Exchange Commission (SEC). FINRA requires a minimum deposit with a brokerage of $2,000, or 100% of the purchase price, whichever is less. This is known as the minimum margin.
How about an example of buying on margin?
Let's say you want to buy 1,000 shares of a marginable stock that's currently trading at $50 per share. If you bought it with only the cash in your account, you'd need $50,000. But if you bought the shares through a margin account, you'd only need to have $25,000 in your account to purchase them—the other $25,000 would be funded by margin, which is borrowed from your broker.
If the stock rises from $50 to $55 per share and you sold it to realize a gain of $5 per share, or $5,000, you'd have a 20% return because you only had to use $25 per share of your own cash. The other $25 per share was paid with funds borrowed from the broker, boosting the return.
But margin cuts both ways. If the stock dropped and you sold it for $45 per share, you'd realize a loss of 20%—double what the loss would be if you paid for the stock entirely in cash. And don't forget, the whole time you're holding a margin loan balance, you're incurring interest on that amount.
What are the risks of margin trading?
Because margin magnifies both profits and losses, it's possible to lose more than the initial amount used to purchase the stock. This magnifying effect can lead to a margin call when losses exceed a limit set either by a broker or the broker's regulating body. This "maintenance margin" limit, which may be increased by the broker without prior notice, often ranges from 30% to 40% instead of the initial 50% required at the time of purchase.
The SEC spells out a pretty clear message. On its website, it says that margin accounts "can be very risky and they are not suitable for everyone." Before opening a margin account, the SEC suggested that investors should fully understand that "you can lose more money than you have invested," and they may be forced to sell some or all of their securities when falling stock prices reduce the value of their securities.
In volatile markets, the SEC explains that "investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls." Some investors "have been shocked" to learn their brokerage has the right to sell their securities bought on margin—without any notification and potentially at a substantial loss to the investor, according to the SEC.
Similar to a bank loan, there is an interest cost associated with borrowing funds through margin. For more information about margin interest charges, contact your broker for specifics.
How does trading on margin work for futures and forex?
Margin requirements—also called performance bonds—for futures and forex trading are substantially lower than stocks, typically ranging from 3% to 15% of the total contract value. Performance bonds are financial guarantees required of both buyers and sellers of futures to ensure they fulfill contract obligations.
Unlike margin on stocks or portfolio margin, margin on futures and forex trading is not a loan. To open a futures position, you must provide a deposit (sometimes called a good faith deposit). The amount of the deposit is the "initial margin" required to open the position. The required margin after opening the position is known as the "maintenance margin" level. If the account's available funds fall below the maintenance level, the account would be in a margin call, and you'd be required to add more funds immediately. Failure to restore the account to required maintenance levels and meet the margin call can result in the liquidation of the futures positions.
Futures initial margins are set by the exchanges (firms may hold higher house requirements) and vary depending on the commodity (market volatility is also a factor). For example, January 2024 CME Group WTI Crude Oil futures required initial margin of $12,342, or roughly 17% of the total contract value. The contract was trading around $72 per barrel in mid-December 2023, meaning one futures contract covering 1,000 barrels of oil had a notional value of about $72,000.
Margin requirements in the retail foreign exchange (forex) market can be even lower—2% to 3% of the total value. "Generally, forex rules allow for the most leverage, followed by futures, then equities," said Nick Theodorakos, managing director of margin risk at Schwab. "Depending on the product, forex and futures leverage can be at 20-to-1 or even 50-to-1 compared to equities' overnight margin of 4-to-1." It's important to note that while futures and forex products offer greater leverage, they also carry a higher risk of loss, potentially greater than the initial investment. Also note that forex trading isn't yet available at Schwab but is anticipated later in 2024.
When used with caution and discipline, leverage can be a valuable tool in a trader's toolbox, but the warning bears repeating: Margin is a double-edged sword. It can magnify losses as well as gains. If you plan to use margin, make sure you understand the risks and be sure to monitor your accounts carefully.
