At its simplest, trading on the margin is borrowing money from your stock broker in order to purchase shares of stock. For example, if you had $5,000 in your trading account, but felt really strongly that shares of a certain company were going to be climbing soon, you could purchase up to $10,000 in shares of that company’s stock. This would mean that you own $10,000 worth of shares, but you also owe $5,000 to your stock broker. If the price of the stock goes up as you hoped it would, you can then sell back the shares at the higher price and pocket the money made using both your $5,000 and the brokers $5,000.
Benefits of Buying on Margin
As shown in the example above, buying on margin has the potential to make a stock market trader twice as much money as he would have made on a given trade. Let’s look at the math. If the investor had purchased $5,000 in shares of a stock with only the cash he had in his account, and then sold those shares after the price went up 10%, that investor would have made $500. Conversely, if an investor had borrowed another $5,000 from their broker and purchased $10,000 worth of shares, and then sold when the stock price went up 10%, that investor would have made $1,000 off of the trade. Simply put, if you are buying on margin then you have the potential to double your profits on any investment.
There are other benefits to buying on margin as well. If you are currently trading via a cash account that does not allow margin trading, you may have noticed that it takes 3-4 days to get the money after selling shares of any given stock. This is due to regulations from the SEC regulations currently in place that require that a trade must “settle” within three days. This means that your broker doesn’t have to give you the money from the trade for three days.
This can be extremely frustrating if you sell shares of a stock and notice another buying opportunity immediately following the sale. The opportunity may be long gone in the time that it takes to “settle” your shares.
With a margin account, the broker will, in essence, lend you the money during the settle period, giving you the ability to make purchases much quicker after selling shares of stock. All of the confusion will happen on the backend, while on your end it will seem as if you are just buying shares as you always do.
A dividend is when a company decides to pay out a portion of its profits to its stock holders. When a company decides to pay out a dividend, all those that own shares on a specific date will be given a certain amount of cash based on how many shares they own. This means that if you know a company is about to offer a dividend, you can purchase twice as many shares with margin trading and receive twice the dividend that you would have received. Please note that making money with dividends is not as easy as this description makes it sound. There are certain strategies to dividend trading, as explained in our market trading courses.
Negatives of Buying on Margin
If you have been reading about the positive potential of buying on a margin, you have likely realized at this point what the downside could be. Earlier we explained that buying on the margin gives an investor the ability to double their profits in a single investment. That potential works two ways. Buying on margin can also double the loss of any given investment.
For example, if an investor were to purchase $5,000 worth of shares of stock, hoping the price would go up, and instead got hit with a 10% price decrease, that investor would lose $1,000 instead of $500. Because of this, margin trading can be very dangerous. Just as the investor will keep all the profits from the shares purchased with cash and loan, the investor takes on all the losses from both the loaned shares and the shares purchased with cash.
If your investment drops more than 50%, then you could be in real trouble. This would mean your losses are more than 100%. You will not only lose your entire initial investment, but will also owe the broker additional funds.
Simply put, trading on the margin means that if you are mistaken on your investment, you will double your losses.
The technicalities of buying on margin are that you have to maintain a ratio of at least 30% equity. Equity is cash, or the total value of stocks owned. Here is an example of what we mean.
Let’s say you have $10,000 in your account and buy on the margin to make a $20,000 purchase. A few days later the share price of the stock you purchased dropped significantly, making the value of your shares $12,000 instead of $20,000. Remember, with trading on margin you always get all the profits or losses, meaning all $8,000 in losses applies to you. This means that of that $12,000 worth of stocks in your account, $10,000 is owned to the broker (they lent you $10,000 to trade on the margin). You only own $2,000 in equity because you took on the $8,000 in losses. This means that you are below the 30% threshold and a margin call will be put in to place.
A margin call means that you have to either deposit money into your account or sell shares of stock in order to meet that 30% threshold.
Usually the investor has five days to take the necessary steps, or the broker can force them to sell their shares, which may be at a highly inconvenient time. The investor will have no say in when the shares sell, or which stocks get sold if a margin call is not met.
You may have been asking yourself what the broker gets out of lending you the money. They get the same thing anyone who lends money gets. Interest. Brokers will charge a monthly interest rate for lending you the money. If you sit on stocks purchased on the margin for a long time you may spend a significant amount in interest. Typical interest rates are between 5 and 10%.
There are two different margin requirements that compare cash to margin. The first is the initial margin requirement. The initial margin requirement is typically 50%. This is the amount the broker will allow when you are first purchasing the stock or security. For example, if you have $5,000 you will be able to purchase a maximum of $10,000.
The other type is the maintenance margin requirement. The typical maintenance margin requirement is 30%. This is the minimum ratio before a margin call occurs and your broker begins to sell your assets.
There is also a concentrated account margin requirement. This applies if you have more than 60% of your money invested in a single company or stock. The broker considers you a higher risk at this point and both the maintenance margin requirement and the initial margin requirement are 50%.
Most brokers have a requirement that a stock market trader have at least $2,000 in their account before they can apply to get a margin account. This can change depending on which broker you go with.
Your broker will most likely not allow you to buy any stock on the margin. Most brokers try to limit traders to stocks that are not as volatile (large increases and decreases in share price). This means you will likely not be able to invest in penny stocks with margin funds, or even a lot of micro-cap stocks, as their share price tends to fluctuate in more extreme ways.
As this site is focused on helping beginners get their feet wet, we would recommend not buying stocks on margin for the first few years. It can be tempting to use, especially when you do not have a lot of funds available and it feels like a 5 or 10% profit isn’t very much. However, unless you are experienced and know what you are doing, buying on margin is a lot like taking out a loan and then heading to vegas with the money.
Here is a recap of what was discussed.
- Buying on margin is borrowing money from your broker to purchase shares of stock.
- Buying on margin has the potential to double your profit or loss after selling shares of stock.
- If the price of stock bought on margin drops significantly, you will have a margin call and be forced to add more money to your account or risk automatic selling of your shares.
- You pay interest on money used to buy on margin
- Margin trading is extremely risky.