What is margin trading? (And is it worth the risk?)

The short version

• Trading on margin allows you to invest with more money than you might have on hand by borrowing money from your broker
• A margin account is a brokerage account in which you can borrow money from your broker, using the cash or securities you already have in the account as collateral.
• While margin trading can result in excellent returns, the biggest downside is that you can lose more money than you originally invested if the stocks prices drops or the broker issues a margin call

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Pros and cons of margin trading

Pros

• It's a viable way to increase returns, especially if you see a time-sensitive opportunity.
• You don’t have to use the entire amount of margin available to you.

Cons

• You can lose more money than you invested.
• Margin calls can force you to sell at the worst possible moment.
• Margin loans come with interest.
• You may incur short-term capital gains taxes on your profitable trades.
• Brokerages can raise their maintenance margin requirements at any time with little notice.

What is margin trading?

When you margin trade or “buy on margin,” you purchase securities or assets using money borrowed from your broker. This allows you to buy more shares than you could with your own cash and hopefully makes a more significant profit if the security price increases before you sell.

You get to keep all your profits above the original margin amount when you trade on margin. This allows investors with smaller accounts to potentially reap considerable market rewards. There is, however, a significant downside — you can lose more money than you originally invested.

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How does margin trading work?

So how does margin trading work? First, choose a broker, such as TD Ameritrade, Fidelity, or Robinhood for your margin account. After you read up on the unique requirements for margin trading with your broker, you can work out what you'll need to get a margin loan, and you can prepare for the event of a margin call.

Margin loans

Margin trading involves taking out a loan from your broker to purchase an asset. The loan amount is determined by the margin requirement, which is the percentage of the securities you must pay with your own cash.

According to FINRA regulations, the initial margin requirement for most stocks is 50%. This means that an investor would need at least $50 in cash to purchase $100 worth of shares. Individual brokers might have even higher margin requirements to compensate for the risk of providing a margin loan.

Like with any loan, you'll be charged interest. The rate depends on which broker you choose and the amount you borrow.

Read more : The best margin rates for 2022

Margin calls

A margin call requires you to immediately deposit additional funds into your account to meet the margin requirement. If you don't do this, your broker may sell some of your securities to increase the value of your account.

Your broker will issue a margin call when the value of your margin account falls below the margin requirement. For example, if you're required to maintain a 50% margin and your account value drops to 45%, you'll receive a margin call. After the margin call, you'll have a specified amount of time to either add cash or sell off some of your assets to bring your account back up to the margin requirement.

This is the most significant risk of using margin on investments, besides the magnified losses. You may be forced by the broker to sell at the worst time possible — like at the bottom of a downturn — which means significant losses for your portfolio.

You can avoid a margin call by always maintaining a margin buffer in your account – that is, never letting your account value fall below the margin requirement. This can be difficult in volatile markets, but it's the best way to avoid a costly margin call.

Read more: What is a margin call?

Margin trading example

Here are two simplified examples of how margin trading can end in amplified profits or losses.

Imagine you have $10,000 in your brokerage account and want to invest in XYZ stock. You feel very strongly about XYZ and decide you want to take on more risk with a margin account. If you take a $10,000 margin loan, you'll have a total of $20,000 of buying power.

You put it all into stock XYZ, which rises 10%, where you close your position at a profit. When you close your position, your account is now worth $22,000. Your broker takes back the original $10,000 it lent you as margin, and you are left with the $10,000 you invested initially, plus $2000 in profit. That's double the $1000 gain you would have made without margin.

On the other hand, you can also lose a lot more than you originally invested. For example, if the stock fell by 60% and your account was worth $8,000 at closing, you would still have to return the $10,000 you borrowed. That means you'd owe $2,000 to your broker and be down $12,000 from when you started.

The bottom line

With margin trading, you can earn massive returns on your capital. But if you make the wrong move, it could also easily wipe out your entire account.

Before you embark on margin trading, it's essential to understand the risks involved and how to manage them properly. Before getting started, you should first feel very comfortable with your trading strategies and understand what is going on in the market.