Margin is the practice of borrowing money from a brokerage to buy financial assets, using the purchased assets themselves as collateral for the loan.
Understanding margin trading
When an investor uses margin, they pay for a portion of a trade with their own cash and borrow the remainder from their broker. The portion paid by the investor is the initial margin. The broker charges interest on the borrowed funds for as long as the loan remains active. The purchased securities remain in the investor’s account, but the broker holds a lien on them. If the investor defaults, the broker can seize the assets to recover the loaned money.
Buying on margin creates leverage. Leverage magnifies potential returns and potential losses. If the price of the purchased stock rises, the profit is calculated against the total position size. If the stock price falls, the losses are similarly calculated against the total position size. Because the investor must repay the borrowed amount regardless of the stock’s performance, it is possible to lose more money than the initial cash deposit.
Brokers require investors to maintain a minimum level of equity in their margin accounts, known as the maintenance margin. If the value of the assets drops below this threshold, the broker will issue a margin call. A margin call requires the investor to deposit additional cash or sell securities to bring the account back up to the minimum requirement. If the investor does not deposit the required funds, the broker has the right to liquidate the positions without prior notice.
The rules governing margin accounts vary by jurisdiction. Different countries have distinct financial regulatory bodies that set maximum borrowing limits to control risk in the markets. The exact percentage an investor can borrow also depends on the specific broker and the historical volatility of the asset being traded.
Example
Suppose you, as a fellow Elephant, want to buy shares in Peanut Farms Ltd. The shares are currently trading at $10 each. You want to buy 1,000 shares for a total position of $10,000. You only have $5,000 in cash. You use your margin account to borrow the remaining $5,000 from your broker to complete the trade.
If the stock price rises to $15, your 1,000 shares are now worth $15,000. You sell the shares and repay the $5,000 loan to the broker, leaving you with $10,000. Excluding interest costs, your $5,000 cash investment generated a 100 percent return, while the underlying stock price only increased by 50 percent.
If the stock price falls to $5, your shares are only worth $5,000. If you sell the shares, the entire $5,000 goes to the broker to repay the loan. You lose your entire initial investment. If the stock drops below $5, your account equity becomes negative, meaning you owe the broker more money than the assets are worth. In this scenario, the broker would issue a margin call well before the stock hit $5 to protect their loan.