Beyond Margin Basics: What You Need to Know

Margin can be a powerful tool, and like many powerful tools, it comes with a risk of injury.

But with proper risk management, investors and traders can put margin to work, raising their buying power and potentially increasing their returns, whether they're trading stocks or options. Below we'll review what margin is and how it works, then explain how it can be used with different asset classes and offer tips for minimizing risk.

Margin debt is money borrowed from a brokerage by a client with a margin-approved account. Using the existing assets in their account as collateral, margin-approved investors and traders can borrow money to buy more securities than they otherwise could in hopes of generating higher returns. They can also use margin as a personal line of credit for whatever purpose they choose.

Securities that can be used as collateral for a margin loan include:

• Cash and money market funds
• Most stocks, exchange-traded funds (ETFs), and exchange-traded notes (ETNs) that are traded on major U.S. exchanges (share-price restrictions sometimes apply)
• Some mutual funds that have been owned for more than 30 days
• Most investment-grade bonds

Assets that cannot be used as collateral on margin loans include:

• Individual retirement accounts (IRAs)
• 401(k) accounts
• Futures positions or options on futures
• Forex positions

There are two types of margin requirements:

• Initial: The minimum amount of equity (cash and/or securities) an investor must have in their account to buy a certain value of securities on margin. For example, a 50% initial margin requirement means an investor must have at least $100,000 in equity to buy $200,000 worth of stock.
• Maintenance: The minimum level of equity investors must maintain in their account after the initial margin purchase to keep the margin loan active. In most cases, this is lower than the initial margin requirement. It's a minimum of 30% for stocks.

Of course, money isn't free. Brokerages charge interest on margin debt. They usually assess interest daily, with balances calculated based on that day's closing prices, and deduct the payment from the client's account monthly. The interest rate depends on the brokerage, which uses a benchmark and adds a spread that depends on the client's account balance—higher balances receive slightly more favorable rates. The rate usually falls somewhere between mortgage and credit card rates but fluctuates according to whatever internal benchmark the brokerage uses.

In most cases, there is no set schedule for repaying a margin loan. The borrower can keep the loan active as long as they wish, provided they meet the margin maintenance requirements. But daily compounding matters more on margin positions held for any length of time, eating into potential profits. It can be particularly costly during Federal Reserve rate-hike cycles.

Margin-approved investors with a minimum account balance of $2,000 can purchase a range of securities using margin debt. The rules and requirements set by regulators differ by asset class and type of trade. Note that many brokerages set more stringent requirements, and some, including Schwab, use a risk-based concentration model. Under that model, brokerages set maintenance requirements based on the amount of risk seen in a client account's individual positions, using the expected volatility of those positions.

The Federal Reserve Board's Regulation T states that an approved investor can borrow up to 50% of the purchase price of qualified stocks. The other 50% is the initial margin requirement. The Financial Industry Regulatory Authority (FINRA) sets the minimum maintenance requirement for equities at 30%. However, exchanges and brokerages are permitted to set margin requirements that are stricter than those set by regulators.

Traders are required to have a margin-approved account to engage in short selling, which is borrowing stock and selling it with the intention of buying it back later at a lower price, thus profiting from the decline in value.

Brokerages charge fees for lending the shares, and fees are higher for stocks that are difficult to obtain. Many brokerages also charge interest on the margin used to cover the position until the borrowed shares are returned. There is no guarantee the brokerage firm can continue to maintain a short position for any period of time. Your position may be closed out by the firm without regard to your profit or loss.

Day trading is buying and selling (or selling short and buying to cover) the same position on the same day. Pattern day trading refers to executing four or more day trades within five business days in an equities margin account.

FINRA classifies anyone who meets this threshold as a pattern day trader, which triggers specific requirements. Pattern day traders must maintain at least $25,000 in their account. If the account falls below that level, they'll be restricted from day trading until they again meet the requirement.

Pattern day traders also receive additional buying power to use for day trading only: With eligible stocks, they can day trade up to four times the account's regulatory maintenance excess as of the previous day's close. Maintenance excess is the amount by which the equity in the account exceeds the required margin.

Buying puts and calls requires paying the full options premium up front. But certain options strategies—primarily, those that include selling options—do require margin. Selling an option requires collateral to cover potential losses because the trader has taken on an obligation to buy or sell the underlying asset at a specific price.

Common options strategies that require a margin account include:

• Naked calls or puts
• Credit vertical spreads
• Straddle/combo
• Iron condors/butterflies

Keep in mind, margin requirements for options differ by brokerage and strategy.

Portfolio margin is limited to traders who deploy sophisticated options strategies to hedge risk across their portfolios. It offers more leverage—and higher risk—than standard margin. FINRA requires a minimum account balance of $100,000 for portfolio margin, but brokerages often require a higher balance. 

With portfolio margin, margin requirements are based on the Options Clearing Corporation's (OCC) Theoretical Intermarket Margin System (TIMS), which assesses the total risk in a portfolio rather than the size of the leverage in any single position. 

The power of margin cuts both ways. For example, an investor with $10,000 in their margin account buys 1,000 shares of stock trading at $20 per share (or $20,000 worth of stock).

If the stock rises from $20 to $25 per share (a 25% gain in the share price, or a $5,000 increase in the value of the position), the investor has made a 50% profit on their account balance ($5,000 = 50% of the initial balance of $10,000), excluding transaction fees and any interest payments on the margin loan.

But if the stock drops to $15 per share, the investor would lose $5,000, or 50% of their account balance—double what the loss would be if the stock were paid for entirely in cash. They could also face a margin call, a brokerage's formal notification to meet the margin maintenance requirement or face forced liquidation of some or all of their securities.

One of the most important things to know about margin is that big losses can dig a deep hole that would be difficult for any trader to climb out of. Because margin amplifies losses as well as gains, it is more difficult to make up losses over time, particularly after a series of consecutive losses.

Let's look at a typical equities example:

• A trader has $10,000 in their account.
• The initial margin requirement for equities is 50%.
• The margin maintenance requirement is 30%.
• The trader borrows an extra $10,000 and buys $20,000 worth of stock.
• The stock falls 30%:
  • It is now worth $14,000 instead of $20,000.
  • The trader now has $4,000 in equity.
  • The trader must sell $667 of stock to meet the margin requirement of 30% of the market value of the stock (now $14,000), leaving them with $13,333.33 worth of stock.

The following week the stock rises 30%, bringing the total value of the trader's position to $17,333.33, leaving the trader with an account value of $7,999.99.

In other words, even though the stock fell 30% and then rose 30%, the trader's account value dropped slightly more than 20%. And that's before transaction fees and interest are deducted.

Obviously, 30% is a big drop. But even a 10% fall and a 10% increase, while that may not force a sale to meet margin requirements, would leave the trader down 2% ($200) before interest and transaction fees.

A margin call, also known as a maintenance call, occurs when the equity in a margin account falls below the maintenance requirement. When this happens, the brokerage issues a formal demand for the investor to either deposit additional funds or securities (as collateral) or liquidate positions to restore the account to the required maintenance level.

Here's what investors need to know about how margin calls and liquidations work in practice:

• Brokerages can raise requirements without notice. When an investor opens a margin account, they agree to let the brokerage change margin requirements at any time. During market volatility, even in individual securities, firms often raise maintenance requirements, sometimes aggressively and intraday, with little or no advance warning. A position that was comfortably within requirements in the morning might trigger a margin call in the afternoon.
• Forced liquidation can happen without a phone call. Despite the name "margin call," brokerages are not legally required to contact investors before liquidating positions. Many firms use automated risk management systems that trigger immediate sell orders when the account's equity breaches certain thresholds.
• Liquidation serves the brokerage's risk, not a client's position. When a brokerage liquidates positions to meet a margin call, they typically sell the most liquid securities first, target positions with the highest risk, or liquidate across the portfolio. They are not concerned with minimizing investor losses or preserving positions that might be considered most valuable.
• Forced liquidations often occur at unfavorable prices. Margin calls frequently happen during sharp market declines, meaning forced sales can lock in losses at low prices.

• Understand that margin requirements can rise quickly when markets turn turbulent. Asset correlations increase during market stress, limiting the effectiveness of some hedging techniques at a time when fast-moving prices can quickly push traders into the red. Brokerages raise margin requirements at these times. Traders should be ready for requirements to jump overnight or even intraday.
• Have a plan. Develop a risk-management strategy that is consistent with your market outlook and stick to it. Be ready to deal with a possible margin call, rising maintenance requirements, or climbing margin interest rates.
• Don't get fully leveraged. If a trader plans to buy securities on margin, they should consider borrowing less than the maximum available to them. Trading at maximum leverage leaves less cushion before a margin call forces a liquidation of part or all of a trader's position(s).
• Keep a separate cash reserve earmarked for rising margin requirements during times of volatility.
• Place stop orders based on margin percentages, not just a security's price.
• Borrow against a diversified portfolio. If a trader's equity (collateral) is already in securities, diversification may help prevent a decline in one or two securities from triggering a margin call.
• Stay updated on market activity and account changes. Traders should anticipate potential declines during growing volatility and frequently reassess their exposure and risk tolerance.

Trading futures contracts also requires a margin account (and separate approval for futures trading), whether the underlying asset is a commodity, currency, or stock index. Futures margin, also known as a "performance bond," is the amount of money a trader is required to deposit in their futures account to establish and maintain a futures position. Futures margin is not a loan. If at any given time the funds in a futures account drop below the minimum regulatory requirement, or "house" margin requirements, traders may be required to immediately deposit additional funds to maintain their position, or their position may be liquidated at a loss, leaving them liable for any resulting debits.

Margin requirements for futures can be increased at any time and forced liquidations can occur, both without prior notice. It's important to understand all the differences and risks with how margin works in futures trading.

Traditionally, futures markets were the domain of professional traders and those involved in trading physical commodities who sought to either hedge risk or speculate. Exchanges set minimum funding requirements for futures contracts, and brokerages can set stricter requirements.

Margin debt is kind of like credit card debt: You don't want to be maxed out all the time. Use margin judiciously, where you think your market edge is strongest, and spend more time preparing for worst-case scenarios than imagining best-case scenarios. That way you'll be more likely to use the power of margin.