Call

  • Schwab Brokerage

    800-435-4000

  • Schwab Password Reset

    800-780-2755

  • Schwab Bank

    888-403-9000

  • Schwab Intelligent Portfolios®

    855-694-5208

  • Schwab Trading Services

    888-245-6864

  • Workplace Retirement Plans

    800-724-7526

More ways to contact Schwab

Video

How Does Margin Trading Work?

Margin trading requires a margin account. This is a separate account from a “cash account,” which is the standard account most investors open when they first start trading.

All securities in your margin account (e.g., stocks, bonds) are held as collateral for a margin loan. If you fail to meet a margin call by depositing additional assets, your broker may sell off some or all of your investments until the required equity ratio is restored.

The maintenance requirement varies from broker to broker. This is the ratio between the equity of your holdings and the amount you owe. In other words, it’s how much you can borrow for every dollar you deposit. The brokerage firm has the right to change this at any time. The interest rate your broker charges on margin loans is subject to change as well.

It is possible to lose more money than you invest when margin trading. You will be legally responsible for paying any outstanding debt.

Margin Trading Scenario 1

Imagine an investor deposits $10,000 into an otherwise empty margin account. The firm has a 50% maintenance requirement and is currently charging 7% interest on loans under $50,000.

The investor decides to purchase stock in a company. In a cash account, they would be limited to the $10,000 they had deposited. However, by employing margin debt, they borrow the maximum amount allowable, $10,000, giving them a total of $20,000 to invest. They use nearly all of those funds to buy 1,332 shares of the company at $15 each.

After buying the stock, the price falls to $10 per share. The portfolio now has a market value of $13,320 ($10 per share x 1,332 shares). Even though the value of the stock fell, the investor is still expected to repay the $10,000 they borrowed through a margin loan.

The Problem With This Scenario

Aside from the outstanding debt, this scenario presents another serious problem. After accounting for the $10,000 debt, only $3,320 of the stock value is the investor's equity. That makes the investor's equity roughly 33% of the margin loan. The broker issues a margin call, forcing the investor to deposit cash or securities worth at least $6,680 to restore their equity to the 50% maintenance requirement. They have 24 hours to meet this margin call. If they fail to meet the maintenance requirement in that time frame, the broker will sell off holdings to pay the outstanding balance on the margin loan.

Had the speculator not bought on margin and instead only bought the 666 shares they could afford with cash, their loss would have been limited to $3,330. Furthermore, they wouldn't have to actualize that loss. If they believed the stock price would bounce back, they could hold their position and wait for the stock price to rise again.

However, since the trader in this scenario used margin trading to buy the stock, they must either cough up an extra $6,680 to restore the maintenance requirement and hope the stock bounces back, or sell the stock at a $6,680 loss (plus the interest expense on the outstanding balance).

Margin Trading Scenario 2

After purchasing 1,332 shares of stock at $15, the price rises to $20. The market value of the portfolio is $26,640. The investor sells the stock, pays back the $10,000 margin loan, and pockets $6,640 in profit (though this doesn't account for interest payments on the margin loan). If the investor hadn't used margin to increase their buying power, this transaction would have only earned a profit of $3,333.

What’s the difference between margin trading and short selling?

There are some similarities between margin trading and short selling since both involve additional risks. However, the mechanics of short selling are much different from margin trading.

Short selling means borrowing shares from your brokerage with the intent of buying them back at a lower price. That strategy works when the share price falls, but it can easily backfire. If the stock goes up, you lose money, and, unlike owning a stock, your losses are theoretically unlimited.

In this sense, short selling is even riskier than margin trading because you can be on the hook for an unlimited amount of money. With margin trading, you’re only at risk of losing what you’ve invested and borrowed. Like margin trading, short selling generally requires traders to put up collateral, and a short seller can also be subject to a margin call forcing them to close out their bet.

What margin trading does have in common with short selling is that it should only be considered by very experienced investors who fully recognize the risks. Even then, those investors who want to use them should carefully limit their total exposure so that, when the market moves against them, it doesn’t jeopardize the rest of their financial position.

While margin trading can be advantageous at times, overall the risks of borrowing from your brokerage outweigh the benefits. 

Understanding Margin

Margin refers to the amount of equity an investor has in their brokerage account. "To margin" or "buying on margin" means to use money borrowed from a broker to purchase securities. You must have a margin account to do so, rather than a standard brokerage account. A margin account is a brokerage account in which the broker lends the investor money to buy more securities than what they could otherwise buy with the balance in their account.

Using margin to purchase securities is effectively like using the current cash or securities already in your account as collateral for a loan. The collateralized loan comes with a periodic interest rate that must be paid. The investor is using borrowed money, or leverage, and therefore both the losses and gains will be magnified as a result. Margin investing can be advantageous in cases where the investor anticipates earning a higher rate of return on the investment than what they are paying in interest on the loan.

For example, if you have an initial margin requirement of 60% for your margin account, and you want to purchase $10,000 worth of securities, then your margin would be $6,000, and you could borrow the rest from the broker.

What Does It Mean to Trade on Margin?

Trading on margin means borrowing money from a brokerage firm in order to carry out trades. When trading on margin, investors first deposit cash that then serves as collateral for the loan and then pay ongoing interest payments on the money they borrow. This loan increases the buying power of investors, allowing them to buy a larger quantity of securities. The securities purchased automatically serve as collateral for the margin loan.

Firm Practices

Firms have the right to set their own margin requirements—often called “house” requirements—as long as they are higher than the margin requirements under Regulation T or the rules of FINRA and the exchanges. Firms can raise their maintenance margin requirements for specific volatile stocks to ensure there are sufficient funds in their customers’ accounts to cover large price swings. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call. Again, a customer’s failure to satisfy the call may cause the firm to liquidate a portion of the customer’s account.

Tools to help make informed trading decisions

Margin calculator View any position’s current margin requirements, calculate the impact of hypothetical trades, and see how price changes can affect your margin requirements and balances. Learn more about the Margin calculator Margin alerts Subscribe to receive margin call notifications and other alerts via email, Active Trader Pro® message center, or mobile device. Sign up for alertsLog In Required

Understand Margin Calls – You Can Lose Your Money Fast and With No Notice

If your account falls below the firm’s maintenance requirement, your firm generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm’s maintenance requirement.

Always remember that your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm’s maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

Recognize the Risks

Margin accounts can be very risky and they are not suitable for everyone. Before opening a margin account, you should fully understand that:

  • You can lose more money than you have invested;
  • You may have to deposit additional cash or securities in your account on short notice to cover market losses;
  • You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
  • Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines. Know that your firm charges you interest for borrowing money and how that will affect the total return on your investments. Be sure to ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.

Pros Explained

  • Can buy more than your cash account would allow: Your cash account limits you to the cash you have on hand. If there's an investment you're interested in, you can invest significantly more with margin trading.
  • Could realize higher returns by investing borrowed funds: The more stock you buy, the more you can potentially earn. Margin trading amplifies your returns.

The benefits of margin

When used for investing, margin can magnify your profits—and your losses. Here’s an example of the potential upside. (For simplicity, we’ll ignore trading fees and taxes.)

Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year passes, and that stock rises to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.

A gain without margin

You pay cash for 100 shares of a $50 stock

-$5,000

Stock rises to $70 and you sell 100 shares

$7,000

Your gain

$2,000

Here’s what happens when you add margin into the mix. As we saw above, $5,000 in cash gives you buying power totaling $10,000—your existing cash, plus another $5,000 borrowed on margin from your brokerage firm—allowing you to buy 200 shares of that $50 stock.

A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000, plus $400 of interest,1 which leaves you with $8,600. Of that, $3,600 is profit.

A gain with margin

You pay cash for 100 shares of a $50 stock

-$5,000

You buy another 100 shares on margin

$0

Stock rises to $70 and you sell 200 shares

$14,000

You repay margin loan

-$5,000

You pay margin interest

-$400

Your gain

$3,600

So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 for a gain of 72%.

What’s Considered “Margin?”

Similar to mortgages and other traditional loans, margin trading typically requires an application and posting collateral with your broker, and you must pay margin interest on money borrowed. Margin interest rates vary among brokerages. In many cases, securities in your account can act as collateral for the margin loan. (A TD Ameritrade account that’s approved for margin trading must have at least $2,000 in cash equity or eligible securities and a minimum of 30% of its total value as equity at all times.)

How About an Example of Trading on Margin?

Let’s say you want to buy 1,000 shares of a stock that’s currently trading at $50 per share. If you bought it with only the cash in your account, you’d need $50,000. But if you bought the shares through a margin account, you’d only need to have $25,000 in your account to purchase them—the other $25,000 would be funded by margin.

If the stock rises from $50 to $55 per share (for a gain of $5 per share, or $5,000), you’d have a 20% profit, because the gain is based on the $25 per share paid with cash and excludes the $25 per share paid with funds borrowed from the broker.

But margin cuts both ways. If the stock dropped to $45 per share, you’d have a loss of 20%—double what the loss would be if you paid for the stock entirely in cash.

What is a margin call?

When you have a margin loan outstanding, your broker may issue something known as a margin call, particularly if the market moves against you. When you get a margin call, your broker can demand you pony up more cash or sell out positions you currently own in order to satisfy the call. If you can’t cover the call, your broker will liquidate your positions to get it covered.

If your broker starts selling out your positions, that broker doesn’t care about your tax situation, your view of the company’s long-term prospects, or anything else other than satisfying the call. If the market really moves against you — say the company whose stock you bought on margin declared bankruptcy and the stock became worth $0 — you’re still on the hook for your borrowed funds.

Additional Information

  • SEC Investor Bulletin: Understanding Margin Accounts
  • For additional information on margin in the context of online trading, investors should read Notice 99-11 (February 1999) and the Securities and Exchange Commission’s (SEC) Tips for Online Investing at the SEC website.

Tags

Leave a Reply

Your email address will not be published.