What is margin?
Margin refers to money borrowed to buy an investment, and the margin is the difference between the purchase price and the loan amount.
When you buy stocks on margin, you’re essentially borrowing money from your brokerage firm to increase your purchasing power. It can be a great way to amplify your profits if the stock prices go up, but beware: if the stock prices take a nosedive, your brokerage firm can sell your shares and pay off the loan plus interest. So before you margin trade, make sure you have enough cash in your account to cover a margin call—just in case.
Investing with margin offers several benefits. These include:
- Increased buying power allows you to buy more shares of a stock than you could with just your cash reserves.
- Significant potential for profit, since you can control a more prominent position in the market with a margin.
- The ability to leverage your investment magnifies any gains or losses on the underlying security.
Risks associated with margin investing include:
- The potential for more significant losses if the stock price falls and you can’t meet a margin call.
- Interest payments on the margin loan can add up over time if the stock doesn’t move in your favor.
- Possibly being forced to sell stocks at a loss to repay the loan.
- The chance that the margin rate could increase, which could lead to considerable losses if the stock price falls.
Here are a few tips for using margin responsibly:
- Invest only with margin money you can afford to lose.
- Make sure you understand the risks involved in margin investing.
- Stay up to date on your stocks and the overall market so you can make informed decisions about whether to hold or sell positions.
- Keep an eye on your account balance and margin level, and be prepared to deposit more cash if needed.
- Never use margin to buy penny stocks or other highly speculative investments.
Margin case study
Here’s an example of a margin call in action: Let’s say you buy 100 shares of XYZ stock for $20,000, using $10,000 of your own money and $10,000 borrowed from your brokerage firm. Your brokerage firm has a maintenance margin requirement (MMR) of 25%.
You use the following formula:
Account value = (margin loan) / (1 – MMR).
With this, you can calculate when a margin call will be made.
A margin call would be triggered if your investment value falls below $13,333.33 or $133.33 per share.
So, if the stock price were to fall to $130 per share, the account would be worth $13,000. This would mean your account equity is $3000 ($13,000 – loan). With the account value below the maintenance margin requirement of $3250 ($13,000 * 25%), your broker will trigger a margin call of $250 ($3250 – $3000).
If you cannot meet the margin call, your broker will sell some of your shares to repay the loan.
The bottom line
Margin is money you borrow from your broker to buy an investment. If you don’t have enough cash in your account to cover the loan, your broker can sell some of your shares to cover it. Investing with margin can be pretty incredible—you get to buy more investments and potentially earn more profit. Just be aware of the risks—if things go south, you could end up owing your broker a lot of cash! So only invest with money you can afford to lose.