Understanding Margin Trading: An Investor’s Guide

Margin Requirements and Margin Calls

With a margin account you need to ensure your “buying power” remains above zero. If you opened a new margin account with $50,000 cash deposited to your account, your buying power is easy to figure out: it’s simply $50,000. But suppose you want to buy securities that have a margin requirement of 30%.

This means your maximum opening position size could be as high as $166,500 since you could put up $50,000 cash and the brokerage is willing to extend $116,500 to borrow in order to buy more shares (a 30% margin requirement on $166,500 = $50,000). As a quick rule of thumb, securities with a margin requirement of 30% would allow you to borrow 3.33:1.

Let’s say you decide to buy $100,000 worth of a security that has a margin requirement of 30%, and not the full $166,500 your buying power affords. Your total equity position would be $100,000. And because the margin requirement on this holding is 30%, that means your margin required is $30,000. Since you had $50,000 in cash before the trade, if we subtract this margin required of $30,000, your buying power left is now $20,000.

It's important to keep an eye on your buying power. If you use a lot of margin and/or if your positions lose value, it’s possible for this number to actually become negative. If that happens you would be faced with what’s called a “margin call”. Your brokerage may ask you to deposit more cash to your account or to sell some securities to bring your buying power back out of negative territory.

Pros and Cons of Trading on Margin

It should be clear that margin trading can either magnify gains or losses. With a margin account you can also instantly access borrowed funds. As with any loan, there is interest to pay on borrowed funds and this will serve as a drag on your returns, but the rate of interest charged by brokerages is generally very low. This is because these are secured loans – the securities purchased act as collateral which reduces the risk to the lender versus unsecured loans which charge much higher rates of interest.

One of the bigger risks to be aware of is how margin calls can affect your performance when your trades are not going in the direction you had hoped. With a buy and hold approach without margin, if a stock dropped in value and you were patient, you could hold your position in the hopes of the share price regaining its value. But with a margined position, if you get hit with a margin call you may be asked to either add more cash to keep your trade open, or partially exit your trade at a potentially inopportune time in order to keep your account’s buying power above zero.

To reduce the risk of margin calls you could consider the following strategies:

• Using margin with a diversified portfolio is generally going to be less risky than using margin with individual security positions.
• You don’t need to borrow the maximum amount allowed. Keeping a healthy buffer in your buying power available not only reduces the risk of margin calls, it could allow you to be opportunistic in response to a market downturn.
• You could learn about risk mitigation strategies such as stop loss and trailing stop loss orders that you could use in tandem with margin to limit losses or lock in gains.

Examples of Using Margin

For the right investors and situations, borrowing to invest could allow you to be more flexible with your cash flow management. For example, suppose you had a personal expense and were considering selling some stock to fund the expense. You could borrow against those securities instead.

Alternatively, if you normally get a year-end bonus but the market has a correction at the beginning of the year, you could use margin to try and capitalize on the possible opportunity and cover your loan when you get your bonus. And of course, some people may employ leverage simply because the cost of borrowing is expected to be lower than the rate of return on the borrowed securities.

Other Features of Margin Accounts: Short Selling and Options Trading

A margin account is also the only account that can allow you to directly short sell a security, which means you sell a stock first in the hopes of buying it later at a lower price to close the transaction. This allows you to make money when a stock falls in value. You are effectively trying to buy low, and sell high, but in reverse: you hopefully sell high first, and then buy low later. This requires borrowing the stock from the brokerage.

Concluding Thoughts

Trading on margin is generally not advisable for beginner investors. Even many experienced investors forego using margin or other types of leverage with their investments. Margin and margin accounts are in no way required tools to be a successful investor.

However, if you have a very high-risk tolerance and capacity to stomach losses, and have taken the time to learn more than just the basics of investing, you might be curious if margin is right for you. If you do fall into this category, hopefully now you have a better appreciation of not just the potential performance increase margin offers, but also the downside considerations as well.

To learn more about margin accounts and margin investing, you can visit the BMO InvestorLine learning centre and watch the free course for advanced investing strategies which includes some visual examples of margin and margin trades.