You’ve heard of margin, but do you REALLY understand what it means?
Imagine having the power to buy more stock than your cash would allow, but also knowing how to manage the risks that come with borrowing money.
In this post, we’ll break down margin, margin requirements, margin calls, and buying power, so you can confidently use margin when you’re ready to trade without being caught off guard by the risks.
What is Margin?
At its core, margin is a loan from your brokerage.
When you open a margin account, your broker allows you to borrow money to buy more stocks or securities than you could with just the cash in your account. This borrowing power can help you amplify your gains (or losses) because you’re using both your own funds and borrowed money.
For example, if you have $1,000 in your margin account, your broker might allow you to buy up to $2,000 worth of stock, depending on the margin rate and the type of asset you’re purchasing.
Margin increases your purchasing power, but remember—you’re borrowing money, and borrowed money comes with risk.
Day traders typically use margin accounts rather than cash accounts.
Here’s why:
- Leverage: Margin accounts allow traders to borrow money from their broker to increase their buying power, giving them the ability to control larger positions than they could with just the cash in their account. This is crucial for day traders who often seek to make profits on small price movements and need higher capital to make the trades worthwhile.
- Avoiding Settlement Periods: Under U.S. regulations, there’s a settlement period for trades, typically T+2 (transaction date plus two business days) for stocks. This means when you sell a stock, you must wait two days before you can use that cash to buy another stock without it being considered a “free riding” violation. However, with a margin account, traders can bypass this waiting period since they’re essentially borrowing against their portfolio’s value. This is particularly useful for day traders who might make several trades within this settlement window.
- Frequent Trading: In the U.S., the Pattern Day Trader (PDT) rule applies to margin accounts, requiring a minimum account balance of $25,000 for those making more than three day trades within five business days. The PDT rule does not apply to cash accounts, but the limitations of cash accounts (like the need to wait for funds to settle after each trade) make them less practical for frequent day trading.
Key Takeaway: Most day traders prefer margin accounts because they provide leverage and faster access to capital, both of which are essential for frequent trading. However, margin accounts come with added risks, so understanding how margin works is crucial before jumping in.
Margin Requirements
Every broker has specific margin requirements. These are the minimum amounts of equity (your own money) you must maintain in your account before the broker allows you to use margin.
There are two main types of margin requirements:
- Initial Margin: This is the amount of your own money you need to have before you can borrow from your broker. For example, if a stock requires a 50% margin, you’ll need to pay half of the stock’s purchase price with your own cash, and your broker will loan you the other half.
- Maintenance Margin: Once you have stocks purchased on margin, you’ll need to maintain a certain level of equity in your account. This is typically around 25% of the total value of your positions, but it varies by broker. If your equity falls below this level, your broker may issue a margin call.
Margin requirements ensure you always have a certain amount of your own money at risk, reducing the chance of borrowing too much.
What is a Margin Call?
A margin call happens when the value of your account falls below the maintenance margin required by your broker. When this happens, your broker will require you to deposit more funds or sell some of your positions to bring your account back into compliance.
Let’s say you bought $10,000 worth of stock on margin, with $5,000 of your own money and $5,000 borrowed. If the stock’s value drops, your account equity may fall below the required maintenance margin. The broker may issue a margin call, requiring you to either:
- Deposit more money into your account.
- Sell some of your positions to pay down the loan.
A margin call is your broker’s way of making sure you don’t fall too far into debt. If you don’t meet a margin call, your broker can liquidate your positions, sometimes at a loss to you.
Buying Power with Margin
One of the biggest appeals of trading with margin is the increased buying power it provides. Buying power refers to the total amount of stock or securities you can purchase using both your own money and the margin loan from your broker.
Most brokerages offer something called 2:1 margin for stocks, meaning that for every dollar you have in your account, you can buy $2 worth of stock. If you have $1,000 in your account, you can buy up to $2,000 worth of stock. However, for day traders, some brokers offer 4:1 margin, which can significantly increase your buying power but also your exposure to risk.
For example, with $1,000 in your account and 4:1 margin, you could buy up to $4,000 worth of stock. But if the stock price drops, you may face a margin call quickly because your account’s equity can fall just as fast.
Margin gives you more buying power, but it also magnifies your risk, especially with day trading strategies that involve frequent trades and small price movements.
The Risks of Using Margin
It’s important to remember that trading on margin amplifies both gains and losses. While you can increase your buying power, you can also lose more than your initial investment if the trade goes against you. If your account value drops significantly, you may face margin calls and be forced to sell at a loss.
Some key risks include:
- Increased losses: If the trade moves in the wrong direction, losses on margin can exceed your initial investment. In most cases, you will receive a margin call before your losses exceed your initial investment to prevent your account from going negative.
- Margin calls: If your account value falls too low, your broker can force you to deposit more funds or sell positions.
- Interest costs: Borrowing money isn’t free. Your broker charges interest on the margin loan, which can add up over time.
Margin Examples for Beginners
Here are some easy-to-understand examples using Stock A (which rises in value) and Stock B and C (which decline in value and trigger a margin call). These examples assume a 2:1 margin ratio, meaning you can borrow $1 for every $1 of your own money, and a 25% maintenance margin requirement.
Example 1: Stock A Rises in Value (You Make a Profit)
- Initial Investment:
- You have $1,000 of your own money and borrow another $1,000 from your broker, giving you $2,000 in total to buy Stock A.
- You purchase 100 shares of Stock A at $20 per share.
- Stock A Price Increases:
- After some time, the price of Stock A rises from $20 to $30 per share. Now your 100 shares are worth $3,000 (100 shares x $30).
- Sell the Stock for a Profit:
- You decide to sell all 100 shares at $30 per share, giving you $3,000.
- First, you repay the $1,000 you borrowed from the broker.
- The remaining $2,000 is yours. Since you originally invested $1,000 of your own money, you’ve made a $1,000 profit on this trade.
Summary:
- You used margin to double your buying power.
- Stock A increased in value, allowing you to make a $1,000 profit (100% return on your original $1,000 investment).
- No margin call occurred because the value of Stock A went up.
Comparing Results: Using Margin vs. Your Own $1,000
Let’s break down what would happen if you invested only your own $1,000 in Stock A, without using margin.
Without Margin:
- You invest $1,000 of your own money to buy 50 shares of Stock A at $20 per share (since $1,000 ÷ $20 = 50 shares).
- The price of Stock A rises from $20 to $30 per share.
- Your 50 shares are now worth $1,500 (50 shares x $30).
- You’ve made a profit of $500 on your original $1,000 investment.
With Margin (Example 1 Recap):
- You invest $1,000 of your own money and borrow another $1,000, giving you $2,000 to buy 100 shares of Stock A at $20 per share.
- The price of Stock A rises from $20 to $30 per share.
- Your 100 shares are now worth $3,000 (100 shares x $30).
- After repaying the $1,000 loan, you have $2,000 remaining, for a $1,000 profit.
The Difference:
- Without Margin: $1,000 investment → $500 profit → 50% return.
- With Margin: $1,000 investment (plus $1,000 borrowed) → $1,000 profit → 100% return.
Key Takeaway: By using margin, you effectively doubled your buying power, which also doubled your profit. While you would have made $500 with just your own $1,000, margin allowed you to make $1,000 instead—showing how margin can amplify your returns when a trade goes in your favor.
However, keep in mind that this same leverage also increases your potential losses, as shown in Example 2. Margin is powerful, but it comes with risks!
Example 2: Stock B Declines in Value (Margin Call Triggered)
- Initial Investment:
- You have $1,000 of your own money and borrow another $1,000 from your broker, giving you $2,000 in total to buy Stock B.
- You purchase 100 shares of Stock B at $20 per share.
- Stock B Price Declines:
- Unfortunately, the price of Stock B drops from $20 to $12 per share. Now your 100 shares are worth $1,200 (100 shares x $12).
- You’ve lost $800 in total value.
- Margin Call Triggered:
- Since the value of your account has dropped, the broker checks to make sure you still have enough equity to meet the 25% maintenance margin requirement.
- The total value of your shares is $1,200, and 25% of this is $300.
- But your own equity is only $200 (the $1,200 value of the shares minus the $1,000 you owe the broker). You need to have at least $300 in equity, so you’re $100 short.
- Broker Issues a Margin Call:
- You now receive a margin call, which means the broker is asking you to either:
- Deposit $100 more into your account to meet the margin requirement.
- Sell some shares to reduce the margin loan and raise your equity.
- You now receive a margin call, which means the broker is asking you to either:
- If You Don’t Meet the Margin Call:
- Let’s say you don’t have the extra $100 to deposit.
- The broker will then sell a portion of your shares to bring your account back into compliance. They may sell enough shares to raise $100 in equity or liquidate the position entirely to cover the loan.
Summary:
- You borrowed on margin, but Stock B decreased in value.
- The decline triggered a margin call because your equity fell below the required 25%.
- You either have to add more funds or sell shares to meet the margin requirement.
Example 3: Stock C Declines in Value and Triggers a Margin Call
- Initial Investment:
- You have $5,000 of your own money and borrow $5,000 from your broker, giving you $10,000 to buy Stock C.
- You purchase 200 shares of Stock C at $50 per share ($10,000 ÷ $50 = 200 shares).
- Stock C Price Declines:
- The price of Stock C falls from $50 to $35 per share.
- Now, your 200 shares are worth $7,000 (200 shares x $35).
- Equity Calculation:
- The total value of your account is now $7,000, but you still owe the broker the $5,000 loan.
- Your equity is the value of your account minus the loan:
$7,000 – $5,000 = $2,000 equity.
- Maintenance Margin Requirement:
- Let’s assume your broker has a 25% maintenance margin requirement. This means you need to maintain at least 25% of the total value of your securities in equity.
- The total value of your shares is now $7,000, so 25% of this is $1,750 (25% of $7,000 = $1,750).
- Since your current equity is $2,000, you’re still above the minimum maintenance margin for now.
- Further Decline:
- But what if Stock C drops even more, say to $30 per share?
- Now, your 200 shares are worth $6,000 (200 shares x $30).
- Your equity is now $6,000 – $5,000 = $1,000 equity.
- Margin Call Triggered:
- The total value of your account is now $6,000, and 25% of that is $1,500 (25% of $6,000 = $1,500).
- But your equity is only $1,000, which is below the required $1,500.
- This triggers a margin call because your equity has fallen below the maintenance margin requirement.
- Responding to the Margin Call:
- You receive a margin call, and your broker requires you to either:
- Deposit $500 to bring your equity back up to the required $1,500.
- Sell some shares of Stock C to reduce your loan and restore the margin balance.
- You receive a margin call, and your broker requires you to either:
- If You Don’t Respond:
- If you don’t meet the margin call, your broker can automatically liquidate some or all of your shares to bring your account back into compliance.
Conclusion
Trading on margin can be a powerful tool for increasing your buying power and potential returns, but it’s not without its risks. Understanding the basics—like margin requirements, margin calls, and how buying power works—is essential to using it effectively.
As shown in the examples, while margin can amplify your gains when the market moves in your favor, it can also magnify your losses when prices drop.
Always approach margin with caution, keeping in mind the potential for both profit and loss. By managing risk properly and being prepared for margin calls, you can confidently integrate margin into your trading toolbox.