Is Stock Margin Trading Worth It?

Is Stock Margin Trading Worth It?

Stock investing can be a great way of preserving and growing your wealth. The stock market is home to thousands of companies from different industries that can add value to your investment portfolio. However, stock investing can also be a long and drawn-out process and may require a decent amount of capital to generate sufficient returns. Another way for investors to trade stock is by using a margin. Margin trading involves borrowing money from your stockbroker to buy stocks. This allows traders to increase the buying power of their accounts and gain leverage. However, margin trading is risky and comes with its downsides. Margin trading boosts buying power, but it also amplifies losses. If the account value falls below a certain threshold, the broker may make a margin call and request you to liquidate your positions or add more capital to the account to continue trading. 

Nonetheless, margin trading is a commonly used strategy to boost profits by increasing leverage. If you are interested in how margin trading works in practice, as well as the risks associated with the strategy - this investfox guide is for you. 

What Is Stock Margin Trading?

Margin trading refers to the process of borrowing money from a stockbroker to increase your buying power and make larger trades than what your capital allows for. The rationale behind margin trading is to make the same trades as you would with your own funds, but with an increased sum. This allows traders to make the most out of their strategies in terms of dollar value. 

For example, a 5% return on a trade done with $10,000 is $500. If we assume a leverage of 3:1, the trader would be able to make the same trade with $30,000, which would net them $1,500. 

Margin trading is especially popular among Forex traders, but stock traders also tend to use leverage when dealing with positions of high probability. Choosing whether to use a margin or not depends on the confidence level of the trader, as well as the trade they are planning on executing.

How Does Stock Margin Trading Work?

Margin trading consists of three key aspects that are essential for the process:

  • The margin loan is a secured loan that requires collateral from the trader. The total value of assets held in the trader’s account, including cash and any amount of securities, serve as collateral for the margin loan. The minimum margin requirement may vary from broker to broker, but the industry standard requirement upheld by most brokers is $2,000
  • The credit limit is the upper limit of how much a trader can borrow from the stockbroker. The value of the collateral, as well as the market price of the asset being purchased, are two factors that determine the credit limit for any given trade. In most cases, stockbrokers will allow traders to borrow up to 50% of the purchasing price of the asset. For example, if a trader wants to buy $10,000 worth of stock, the broker may allow them to borrow $5,000, which will require the trader to have at least $5,000 on their account 
  • The brokerage sets the interest rate for the funds borrowed by traders, which varies depending on the amount being borrowed. Interest rates decrease as borrowed funds increase to make it more appealing for larger traders. 

Why Is Margin Trading Considered Risky?

The stock market can be a volatile place. The prices of stocks are constantly changing, which creates an inherent risk for any trading activity. Adding leverage to an already risky trading experience is guaranteed to heighten the overall risk. Trading on margin requires interest rate payments, while the borrowed funds are also at risk. If a margin trade fails and underperforms, the trader may receive a margin call, which restricts additional trades unless the losing trade has been liquidated, or additional funds have been added to the account to pay back the margin. Such trades can be stressful and could lead to panic trading to pay the broker in time. Increased buying power may also prompt traders to take more risks, which might backfire and eventually lead to a margin call. 

 “In addition to magnifying losses as well as gains, leverage carries an extra risk on the downside that isn’t offset by accompanying upside: the risk of ruin.” - Howard Marks

Stock Margin Trading Example

To better understand how margin trading works in practice, let’s look at two scenarios of the same trade. Suppose a trader bought $10,000 worth of stock, out of which $5,000 was financed using leverage. We can compare the results when the stock price rises or falls.

When The Stock Price Rises

Suppose the value of the $10,000 initial stock investment rises by $2,000 and reaches $12,000. 

If the trader sells the position for $12,000 and pays off the $5,000 loan (plus interest), they would be left with the account cash balance minus the loan principal and interest payments. 

In this case, the trader would be left with $7,000, minus the interest payments made during the borrowing period. 

When The Stock Price Falls

If the stock price falls by $2,000 and the value of the investment reaches $8,000 and the trader liquidates the position, they would be left with $3,000, which is less than the initial cash investment made by the trader, which was $5,000. Thus, the trader has actually lost $2,000 because of the trade, plus the interest payments made during the borrowing period. This highlights the loss-amplifying risk of trading stocks on margin. 

Margin Calls and Maintenance Requirements

Margin calls and margin maintenance requirements are some of the most important concepts behind margin trading. They represent the tools used by stockbrokers to protect their funds from reckless margin lending by placing constraints on how much traders can borrow and what thresholds they need to meet to qualify for margin trading. 

Maintenance Requirements

Margin maintenance requirements serve as levers for brokers to halt the client’s ability to make further trades until they have sufficient equity in their account. For example, if the minimum margin maintenance required by a broker is 40% and the total equity value of a client’s account drops below that level, the broker will make a margin call and will require the client to add a sufficient amount of liquidity to their account to meet the 40% threshold again. Unless the client does so, the broker retains the right to liquidate the client’s holdings to cover the margin. The broker may also place additional constraints on the account until further notice. 

Margin Calls

Margin calls are exercised by brokers once the total equity value of a client’s account has dropped below the minimum margin maintenance level. This is done to protect the client’s funds from dropping further in value and making them unable to pay back the borrowed margin. 

Margin calls give the broker full authority to act in their best interest, if the client does not comply to increase the equity value of their account, or cannot do so in time. In this case, the client could face restrictions by the broker, or, in some cases, their account might be closed. 

Additional Margin Trading Risks

 “Almost every financial blow-up is because of leverage.” - Seth Klarman

There are numerous risks associated with trading stocks on margin. Some of these risks include:

  • Elevated loss potential. Margin positions that do not go as planned can place a heavy burden on the entire account of the trader
  • Short-term trades can trigger capital tax bills. If the broker has to liquidate the client’s holdings, the client has no say in which stocks in their portfolio could be liquidated
  • Margin trading is only sensible when the return generated by the trade is higher than the interest rate charged by the stockbroker
  • When covering a margin call requires selling off assets, holding onto the stocks is no longer an option
  • Failure to meet margin calls is also reflected in the client’s credit history, as it would with a bank loan

Key Takeaways From Stock Margin Trading

  • Margin trading is done by borrowing money from a broker to increase buying power and trade more shares
  • Margin trading comes with a minimum cash requirement. Most brokers require a minimum of $2,000 on the account to be eligible for margin trading
  • Margin trading is considered to be a highly risky strategy that could quickly eat into the principal investment made by the client and could even make them insolvent
  • Margin maintenance is a level set by a broker that serves as a threshold after which a margin call is executed
  • When the equity value of an account drops below the maintenance level, the broker reserves the right to liquidate the client’s assets and pay back the margin loan
  • Trading on margin is a viable option only when the returns of a trade exceed the interest payable on the margin loan 

FAQs On Stock Margin Trading

Can you trade stock on margin?

Yes. Most stockbrokers offer margin trading to their clients. However, the maximum leverage amount is usually limited and less than that of Forex brokers. 

Is margin trading risky?

Yes. Margin trading involves risks that may not be as evident when trading with cash. Margin is a loan taken from the broker and represents a liability to the trader. Margin loans are charged interest, which is an additional important consideration for margin traders. 

What is a margin call in stock trading?

A margin call happens when the equity value of a trader’s account falls below the maintenance level set by the broker. Once the margin call has been made, the trader must increase the value of their account, or the broker has the authority to liquidate the necessary amount of their assets to cover the loan and interest.