Three Ways to Use Margin and Leverage

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Narrator: For traders and investors, margin can come in handy when potential opportunities arise. Margin can increase buying power, enable access to advanced trading strategies, and even act as a line of credit. We'll explain margin, discuss its potential risks and benefits, and list the requirements to enable margin in your brokerage account.

Essentially, margin is money borrowed from your broker to buy stocks or other securities. According to the Federal Reserve's Regulation T, investors can borrow up to 50% of the purchase price of a marginable security. For example, an investor with a $5,000 account could borrow an additional $5,000 to purchase up to $10,000 worth of stock. The securities in your account act as collateral, and you pay interest on the money borrowed.

There are two kinds of margin requirements: initial and maintenance. The initial requirement is the amount you need to have up front to enter the position—typically 50% of the stock's purchase price. The maintenance requirement basically requires the securities you borrowed to buy maintain a certain value versus your account balance, typically 30% of the current market value, but it depends on the type of security.

Using margin, you can put up less than the full cost of a trade, enabling larger or more diversified trades. This is called "leverage." When combined with proper risk and money management, leverage can potentially lead to higher returns.

Leverage, of course, is a double-edged sword. Because margin magnifies both profits and losses, losses can be accelerated. This can lead to a margin call, which occurs when your account equity no longer meets the necessary requirements to hold a position on margin. If you do not take action to bring your account back to the minimum requirement, your stock may be sold with or without prior notice. It's even possible to lose more than the initial amount used to purchase the stock. For example, this can happen when a stock bought on margin has a sudden, dramatic down move.

To help avoid this, don't overleverage your account by using all your available buying power at once—set aside some of it in case markets move against you. This can help reduce the likelihood of a margin call, and the remaining buying power can be used to manage a losing position.

In addition to providing leverage, margin can enable the use of advanced stock and options strategies. Some of these require additional account approvals and each carry their own risks, so not all clients will qualify.

And finally, margin can play a role beyond buying and selling securities—specifically, as a line of credit. Whether it's for a large purchase or funds for an emergency, a margin loan can offer an alternative to traditional borrowing.

Like any loan, you'll incur interest charges. However, because margin loans are collateralized by securities, your interest rate may be lower than conventional loans. And some of the interest may be tax deductible, so be sure to check with a tax professional.

Also, you can repay the money when it's convenient—as long as the loan is in good status, and you've met the maintenance requirements.

To qualify for margin, you must deposit cash or eligible securities totaling at least $2,000 in equity and sign the margin agreement. As long as the equity stays above $2,000, margin will be enabled in your account. Please note that margin is not available in all account types.

Ultimately, it's critical to understand the risks of margin along with its benefits to determine whether margin may be right for you. Trading on margin can expose you to additional costs, increased risks, and potential losses in excess of the amount deposited. However, when used properly, margin can be a useful tool for traders and investors alike.

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