Margin can be a powerful tool to leverage your investment returns or to finance purchases apart from your portfolio. Traders should learn all they can about the benefits and risks of employing margin before deciding whether to incorporate it into their trading strategy.
What is margin?
Margin is an extension of credit from a brokerage firm using your own eligible securities as collateral. Most traders typically use margin as a means to purchase additional securities, but there are other uses too. Interest is charged on the borrowed funds for the period of time that the loan is outstanding. There is no set repayment schedule for a margin account loan; however, a certain minimum level of assets must remain in the margin account in order to maintain sufficient collateral.
The use of margin is regulated by financial industry regulatory organizations and certain securities exchanges, and is subject to the policies of the broker-dealer holding the account.
Benefits and features of a margin account
A margin loan can provide a variety of key advantages:
- Leveraging of investments. Buying on margin affords you the potential to achieve greater investment returns by allowing you to own more securities than would be possible on a cash only basis. A margin account also enables you to sell short (borrow shares from your brokerage firm to sell immediately and repurchase them, hopefully, at a lower price in the future) and potentially profit from downward price movements.
- Trading flexibility. Take advantage of timely market opportunities or make investment changes when you want, as long as you maintain the minimum equity required.
- Portfolio diversification. If you hold a concentrated stock position, you can use margin to purchase other securities in order to diversify your portfolio.
- Convenience. Once the margin feature is approved and activated on your account, you can borrow against the account equity at any time without any additional paperwork or waiting for 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 (e.g., and without exclusion, IRAs, 401(k)s, 403(b)s, UGMAs and UTMAs).
- Repayment simplicity. There is no set repayment schedule as long as you maintain the required level of equity in your account.
- Competitive interest rates. Margin borrowing is generally more cost-effective than consumer lending options like credit cards.
- Ready line of credit. A margin loan is a ready source of credit that may be used for purchasing securities or other needs.
- Tax deductibility. Interest on margin loans may be tax deductible against your net investment income. However, you should consult your tax advisor regarding your own situation.
The use of margin can magnify your profits as well as your losses. Let's look at two examples that illustrate the upside potential, as well as the downside risks, of using margin and not using margin to purchase securities. (For the sake of simplicity, these examples do not take in consideration fees and taxes.)
Example 1: the upside potential with and without using margin
A gain achieved without the use of margin
Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year later the price of the stock stands at $70. Your shares are now worth $7,000. You sell your shares and realize a profit of $2,000.
A gain achieved with the use of margin
What happens when you add margin into the mix? This time you use your $5,000 in cash and you also borrow another $5,000 on margin from your brokerage firm. This gives you buying power of $10,000 which allows you to buy 200 shares of that $50 stock instead of only 100 shares.
If, a year later, the stock reaches $70 and your 200 shares are worth $14,000. You sell the shares and pay back the $5,000 margin loan you borrowed plus $400 in interest (this amount will vary depending on the amount of time the money is borrowed and the rate of interest charged by the brokerage firm) which leaves you with $8,600. If you subtract the $5,000 of cash you invested initially, this leaves of profit of $3,600.
Where no margin was used, you earned a profit of $2,000 on an investment of $5,000 for a gain of 40%. Where margin was used—you earned a profit of $3,600 on that same $5,000 for a gain of 72%.
Example 2: the downside risk with and without using margin
Although margin can increase profits when stocks are rising in price, the magnifying effect can work against you as well. Let's look another example, which illustrates the downside risk of using margin and not using margin to purchase securities.
A loss incurred without the use of margin
Jumping back into our first example, what if you use your $5,000 cash to buy 100 shares of a $50 stock, and it goes down to $30 over the course of the next year? Your shares are now worth $3,000, and you've lost $2,000.
A loss incurred with the use of margin
But what if you 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, your shares would be worth $6,000.
If you sell your shares for $6,000, you must pay back the $5,000 loan along with $400* interest, which leaves you with only $600 of your original $5,000—for a total loss of $4,400.
Margin exposure also presents additional risks. When considering a margin loan, you should determine how the use of margin fits your own risk tolerance and investment goals. It is important that you fully understand the risks involved with using margin:
- Leverage risk—Leveraging means using margin to potentially capture more returns than when investing on a cash-only basis. It is important to recognize that unfavorable market moves can negatively impact the value of your investments more rapidly. Leveraging exposes you to greater downside risk versus paying for securities in full because if the securities acting as collateral for your margin loan lose value, you must still either repay your brokerage the amount of money you borrowed on margin or be required to deposit more money into your account.
- Interest rate risk—Like any other loan, you must repay your margin loan along with interest, regardless of the underlying value of the securities purchased. Keep in mind that it is possible that margin interest rates may fluctuate during the time you have an outstanding loan. You may not receive any notice of a margin interest rate change from your brokerage firm.
- Maintenance call risk—If the equity in your account falls below the brokerage firm's minimum maintenance requirements due to a decline in the value of your shares held as collateral, your brokerage firm will issue a "maintenance call." A maintenance call requires you to deposit additional cash or acceptable collateral into your account promptly. Your brokerage firm may increase its margin maintenance requirements at any time without prior notice.
- Forced liquidation risk—If you fail to meet a margin call, your brokerage firm may close-out some or all of the securities in your account without contacting you. You are not entitled to an extension of time on a margin 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.
Tips for managing margin risk
- Don't be fully leveraged—Borrow less than the maximum amount allowable in your account to allow room for fluctuation in the event of an unfavorable market movement. Set a personal minimum account equity level for yourself that is higher than your brokerage firm's house requirements and monitor your portfolio to check that you are not going below that equity level.
- Borrow against a diversified portfolio—This reduces the risk that a single security's drop in value will trigger a margin maintenance call.
- Closely watch your portfolio—Be aware of what is going on in the market. Recognize that margin usage brings increased risk, and constantly reassess your risk tolerance. Anticipate a potential decline in value, especially during uncertain market conditions.
- Have a plan—When you use margin, it’s important to have a trade plan. Develop a risk management strategy for your investments that is consistent with your market outlook, and stick to it. Develop contingency plans for dealing with potential margin calls, and have a repayment plan ready if the market turns, if margin maintenance requirements rise, or if margin interest rates rise.
*The calculations in this example do not take into account all interest charges, commissions or fees.