What to Know About Margin

Margin is basically a loan from a brokerage firm that uses eligible securities as collateral. Traders typically use such funds to buy more securities. (These funds can be used for other purposes, as well, though this is less common.) 

Margin account loans don't have a set repayment schedule, but you must keep a minimum level of assets in the margin account to maintain sufficient collateral. You must also pay interest for as long as the loan is outstanding.

Financial industry regulators and certain securities exchanges oversee the mechanics and rules of margin lending. The broker-dealer holding the account may also have its own policies governing its use.

Margin loans can offer several advantages:

• Leverage. With a margin loan, traders can hold more securities than would be possible on a cash-only basis. That can help magnify profits—as well as losses. A margin account can also be used for short sales, which is when shares are borrowed from another investor and then sold in the hope their prices will fall, at which point the trader would buy them back and profit from the difference. (Note that if the borrowed stock rises instead, then the trader buys the shares back at a loss. Be warned: Since a stock has no upper limit on its price, their loss could potentially be infinite.)
• Trading flexibility. With access to margin, a trader may be more free to pursue potential market opportunities or otherwise adjust their holdings beyond the constraints imposed by their current cash balance—as long as they maintain the minimum equity required.
• Portfolio diversification. A trader with a concentrated stock position who doesn't want to liquidate could use margin to purchase other securities. This could be a way to diversify the portfolio.
• Convenience. Once the margin feature is approved and activated in the account, the trader can borrow against the account equity at any time without any additional paperwork or loan approvals (subject to the terms, limitations, and requirements of the firm's margin agreement). Please note that some types of brokerage accounts are not eligible for margin (for example, IRAs, 401(k)s, 403(b)s, UGMAs, and UTMAs).
• Straightforward repayments. There is no set repayment schedule as long as the trader maintains the required level of equity in the account. 
• More competitive interest rates. Margin borrowing can be more cost-effective than consumer lending options like credit cards.
• Tax deductibility. Interest on margin loans may be tax deductible against net investment income. However, you should consult your tax advisor regarding your situation.

Of course, with potential benefits come potential risks:

• Leverage risk. This is obverse of the point above. When you hold more securities than might be possible on a cash basis, your losses from a drop are that much bigger. Plus, if the securities being used as collateral lose value, you must still either repay the brokerage or deposit more money into the account.
• Interest rate risk. You must pay interest on your margin loan, regardless of the underlying value of the securities purchased. That interest accrues and compounds daily and is charged against the account on a monthly basis. In addition, margin interest rates can fluctuate, but the brokerage may not notify account holders of such changes.
• Maintenance call risk. If your equity falls below the brokerage firm's minimum maintenance requirements, the brokerage firm will issue a "margin maintenance call." If that happens, you are required to deposit additional cash or acceptable collateral into the account promptly. The brokerage firm may increase its margin maintenance requirements at any time without prior notice.
• Forced liquidation risk. If you fail to meet a margin maintenance call, the brokerage firm may close out some—or all—of the securities in the account without notification. You are not entitled to an extension of time on a margin maintenance call. After liquidation, your account may have no value, and you may still owe you brokerage firm for all or part of the original margin loan.

Here are two examples that illustrate the upside potential, as well as the downside risks, of using margin. (For the sake of simplicity, these examples do not consider fees or taxes.)

A trader spends $5,000 cash on 100 shares of a $50 stock. A year later the price of the stock stands at $70. The shares are now worth $7,000. The trader sells the shares and realizes a profit of $2,000.

Now we'll add margin into the mix. This time our trader uses $5,000 in cash and also borrows another $5,000 on margin from the brokerage firm. This gives the trader $10,000, meaning they can buy 200 shares of that $50 stock instead of only 100. A year later, the stock reaches $70, and the 200 shares are now worth $14,000. The trader sells the shares and pays back the $5,000 margin loan, plus $400 in interest (this amount will vary depending on how long they keep the loan active, as well as the rate of interest charged by the brokerage firm), which leaves them with $8,600. If we subtract the $5,000 of cash invested initially, this leaves of profit of $3,600.

To recap: Without margin, the trader earned a profit of $2,000 on an investment of $5,000, for a gain of 40%. With margin, they earned a profit of $3,600 on that same $5,000, for a gain of 72%.

Although margin can increase profits when stock prices rise, the magnifying effect can work against you as well.

Jumping back into our first example, imagine the trader used $5,000 of cash to buy 100 shares of a $50 stock, which then fell to $30 over the course of the next year. The shares would be worth $3,000, and the trader would have lost $2,000.

But what if the trader had borrowed an additional $5,000 on margin and purchased 200 shares of that $50 stock for $10,000? A year later when it hit $30, the shares would be worth $6,000.

To recap: If the trader sold their shares for $6,000, they would have had to pay back the $5,000 loan along with $400 of interest, leaving only $600 of the original $5,000—for a total loss of $4,400. 

With an understanding of the potential risks, traders can consider steps to manage them. 

• Limit the amount of leverage. Borrowing less than the maximum amount allowable in the account can leave room for fluctuations should an investment go the wrong way. Some traders set a personal minimum account equity level that is higher than the brokerage firm's house requirements and monitor the portfolio to check that they are not going below that equity level.
• Borrow against a diversified portfolio. This can reduce the risk that a single security's drop in value might trigger a margin maintenance call.
• Stay vigilant. It's important to be aware of what is going on in the market. Remember that margin can magnify risk, and traders should monitor their risk tolerance. Anticipate potential declines in value, especially during uncertain market conditions.
• Have a plan. When using margin, some traders employ a trading plan and a risk-management strategy that is consistent with their market outlook. It can also make sense to have a contingency plan for dealing with potential margin maintenance calls, as well as a repayment plan ready if the market turns, if margin maintenance requirements rise, or if margin interest rates rise.