How Traders Can Apply Margin

March 7, 2024 Advanced
There are several ways traders can use margin in their trading. Factors for how a trader uses margin include a trader's objectives, risk tolerance, and the products they trade.

Margin is borrowed money that's used to buy stocks or other securities. In margin trading, a brokerage firm lends an approved trader a portion (typically 30% to 50%) of the total purchase price, meaning a trader's buying power increases. Securities in the trader's account act as collateral, and interest is paid on the money borrowed. Because cash and securities in a margin account can act as collateral, some traders choose to use a margin account as a line of credit, designed to have a flexible repayment plan.

Margin loans can serve as a source of flexible borrowing for short-term financial needs, including emergency funding and other personal needs.

This flexible line of credit has a flexible repayment plan, meaning there is no set repayment schedule as long as the required level of equity is held in the trading accounts.

However, there are risks traders  should understand so they can make informed trading decisions.

Here we'll discuss the risks of margin loans as well as the ways a trader approved for margin might incorporate a margin loan into their trading strategy.

Risks of margin loans

Margin magnifies both profits and losses, so it's possible for investors to lose more than the initial amount they used to purchase stock or other assets.

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. If this happens, the broker will attempt to contact the investor. A margin call1 means the investor needs to provide additional funds immediately to maintain the required minimum. If the margin call is not met within a short time frame—often within a single business day—the position may be liquidated or closed by the broker.

The "maintenance" margin limit may be increased by the broker without prior notice, but it often ranges from 30% to 40%, instead of the initial 50% required at the time of purchase.

How can traders and investors use margin?

There are a variety of ways traders can apply margin, depending on the type of investor or trader they are. Here are some ways a margin-approved investor or trader might consider using margin.

Margin for long-term stock investors

Trading stocks on margin is typically governed by Regulation T (Reg T2), under which an investor can borrow up to 50% of the purchase price of securities. This is also known as "initial margin," as some brokerages require a deposit greater than 50% of the purchase price. However, exchanges and brokerages can establish their own margin requirements as long as they're at least as restrictive as Reg T, according to the U.S. Securities and Exchange Commission.

For example, suppose an investor wants to buy 1,000 shares of a stock trading at $20, or $20,000 worth, but has only $10,000 available to invest. With margin, they can borrow an additional $10,000 and purchase all 1,000 shares.

If the stock rises from $20 to $25 a share (a gain of $5 per share, or $5,000), there's a 50% profit because the gain is based on the $10 a share paid with cash and excludes the $10 a share paid with funds borrowed from the broker.

However, if the stock dropped to $15 a share, it becomes a loss of 50%—double what the loss would be if the stock was paid entirely in cash. Moreover, it could lead to a margin call.

As with any loan, when traders buy securities on margin they have to pay back the money borrowed plus interest, which varies by brokerage firm and the amount of the loan. Interest accrues daily at the prevailing rate and is deducted from a trader's account on a monthly basis.

Margin interest rates are typically lower than those on credit cards and unsecured personal loans. There's no set repayment schedule with a margin loan—the principal can be paid down any time. However, there are monthly interest charges that continue to accrue to the account until the principal is paid off. It's important to note, too, that those rates may fluctuate.

Also, margin interest may be tax deductible if used to purchase taxable investments and deductions are itemized (subject to certain limitations; consult a tax professional before proceeding).

As already noted, when used for investing, margin can magnify profits—and losses. While the value of the stocks used as collateral for the margin loan fluctuates with the market, the amount borrowed does not. As a result, if the stocks fall, the equity in the position relative to the size of the margin debt will shrink and could lead to a margin call, increasing the level of market risk.

Traders using margin need to remember that while there's flexibility in paying down the principal of the margin loan, there's no extension of time to meet a margin call.

But margin isn't limited to the long side. Investors with margin privileges can sell stocks short as well, with the aim of making money during, or hedging against, a market decline. Short selling, however, is an advanced trading strategy involving potentially unlimited risks. Consider that when traders buy shares of stock (take a long position), the downside is limited to 100% of the money invested. But when a stock is shorted, its price can keep rising.

In theory, that means there's no upper limit to the dollar amount needed to replace the borrowed shares. It also means there's no guarantee the broker can continue to maintain a short position for any period of time and may close out the position without regard for loss or profit.

Margin for the active trader

For traders and investors who buy and sell frequently, margin can potentially be a handy ally when near-term potential opportunities arise.

Individual investors and traders can apply for a regular margin account with as little as $2,000, but there are rules regarding what's called a "pattern day trader." As defined by FINRA, a pattern day trader is one who executes four or more trades within five consecutive business days in a margin account. These accounts can only open and close a position three times within the same day during that five-day time frame, or else the account will be flagged, and will then need a minimum equity balance of $25,000 or more.

An investor with $25,000 in an account above and beyond any money needed to hold securities, if approved for margin, could have access to $100,000 of day trading buying power. However, if the account's equity drops below the $25,000 minimum for pattern day trading, that account could be subject to a minimum day trading equity call. The image below from the thinkorswim® trading platform highlights how investors can assess the impact of an individual trade before it's made.

Before an order is placed, an investor can assess the trade's impact by looking at the buying power effect, which is the margin needed for the trade, and the resulting buying power for the stock.

Source: thinkorswim platform

For illustrative purposes only.

Margin for stock options traders

Like the options market itself, trading on margin in options is quite different, and often more complicated and risky than equities.

For "defined-risk" options strategies—like long puts and calls or verticals—margin requirements are relatively straightforward. Margin functions like a cash account inside a "margin" account, meaning an investor simply needs to put the cash up for the cost of long trades. Or, in the case of short strategies, such as short vertical spreads3 or iron condors4, investors need to put up the amount at risk.

Short vertical spreads, for example, would require the difference between the strike prices less the net premium received. Remember, if or when investors utilize such strategies, they need to follow the margin rules on the stock or underlying.

For option traders with accounts approved for advanced options strategies who are willing to step further out on the tightrope, it's possible to sell calls or puts "naked," meaning with no hedging position in place to offset any losses.  Margin requirements will vary from broker to broker, usually from 15% to 20% of the underlying value. Keep in mind, however, selling naked options can potentially expose traders to large or unlimited risks.

Margin for the long-term investor seeking short-term financing

Much like other traditional loans, margin requires the posting of collateral to backstop the money that's being borrowed. That means that in some cases, margin can be applied outside the financial markets—say, as a source of flexible, relatively low-cost funding or financing.

However, there are unique risks if margin is used for such purposes, as well potential tax implications. Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs. For example, interest expense would typically only be tax deductible if the proceeds of the debt are used to purchase investments, and those investments generate taxable net investment income. Another risk when using margin as financing is the collateral—the securities in an account—could depreciate and trigger a margin call. At that point, the account holder would be required to deposit funds to meet the margin call. In essence, a margin loan could be called in at any time.

Bottom line

Whichever investor or trader profile fits, it's important to remember that margin can be a useful tool if applied with prudent risk-management techniques. But it's not to be abused or trifled with. Margin offers a number of potential benefits, but it comes with distinctive risks that should be carefully considered.

Carefully read "The Charles Schwab & Co., Inc. Guide to Margin" for more details.

1A margin call is issued when the investment account value drops below the maintenance requirements on a security or securities because of a drop in the market value of a security or when an investor has exceeded their buying power. Margin calls may be met by depositing funds, selling stock, or depositing securities. Schwab may forcibly liquidate all or part of an account without prior notice, regardless of intent to satisfy a margin call, in the interests of both parties.

2The initial margin requirement set by the Federal Reserve Board. According to Reg T requirements, investors may borrow up to 50% of marginable securities that can be purchased (such as most listed stocks).

3Vertical spreads are options positions composed of either all calls or all puts, with long options and short options at two different strikes. The options are all on the same stock and of the same expiration, with the quantity of long options and the quantity of short options netting to zero.

4An iron condor is a defined-risk short spread strategy constructed of a short put vertical and a short call vertical. Traders assume the underlying will stay within a certain range (between the strikes of the short options). The goal: As time passes and/or volatility drops, the spreads can be bought back for less than the credit taken in or expire worthless, resulting in a profit. The risk is typically limited to the largest difference between the adjacent and long strikes minus the total credit received.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options" before considering any options transaction. Supporting documentation for any claims or statistical information is available upon request.

Multiple leg options strategies will involve multiple transaction costs.

Spread trading must be done in a margin account.

Commissions, taxes and transaction costs are not included in this discussion but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

When considering a margin loan, you should determine how the use of margin fits your own investment philosophy. Because of the risks involved, it is important that you fully understand the rules and requirements involved in trading securities on margin. Please read the "Margin Risk Disclosure Statement" for more information.

Margin trading increases your level of market risk. Your downside is not limited to the collateral value in your margin account.

Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account. 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.

Schwab may initiate the sale of any securities in your account, without contacting you, to meet a margin call.

Schwab may increase its "house" maintenance margin requirements at any time and is not required to provide you with advance written notice.

You are not entitled to an extension of time on a margin call.

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. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.