How Traders Can Apply Margin

Margin is borrowed money that's used to buy stocks or other securities. In margin trading, a brokerage firm lends an approved trader a portion (typically 30% to 50%) of the total purchase price, meaning a trader's buying power increases. Securities in the trader's account act as collateral, and interest is paid on the money borrowed. Because cash and securities in a margin account can act as collateral, some traders choose to use a margin account as a line of credit, designed to have a flexible repayment plan.

Margin loans can serve as a source of flexible borrowing for short-term financial needs, including emergency funding and other personal needs.

This flexible line of credit has a flexible repayment plan, meaning there is no set repayment schedule as long as the required level of equity is held in the trading accounts.

However, there are risks traders  should understand so they can make informed trading decisions.

Here we'll discuss the risks of margin loans as well as the ways a trader approved for margin might incorporate a margin loan into their trading strategy.

Margin magnifies both profits and losses, so it's possible for investors to lose more than the initial amount they used to purchase stock or other assets.

This magnifying effect can lead to a margin call when losses exceed a limit set either by a broker or the broker's regulating body. If this happens, the broker will attempt to contact the investor. A margin call¹ means the investor needs to provide additional funds immediately to maintain the required minimum. If the margin call is not met within a short time frame—often within a single business day—the position may be liquidated or closed by the broker.

The "maintenance" margin limit may be increased by the broker without prior notice, but it often ranges from 30% to 40%, instead of the initial 50% required at the time of purchase.

There are a variety of ways traders can apply margin, depending on the type of investor or trader they are. Here are some ways a margin-approved investor or trader might consider using margin.

Trading stocks on margin is typically governed by Regulation T (Reg T²), under which an investor can borrow up to 50% of the purchase price of securities. This is also known as "initial margin," as some brokerages require a deposit greater than 50% of the purchase price. However, exchanges and brokerages can establish their own margin requirements as long as they're at least as restrictive as Reg T, according to the U.S. Securities and Exchange Commission.

For example, suppose an investor wants to buy 1,000 shares of a stock trading at $20, or $20,000 worth, but has only $10,000 available to invest. With margin, they can borrow an additional $10,000 and purchase all 1,000 shares.

If the stock rises from $20 to $25 a share (a gain of $5 per share, or $5,000), there's a 50% profit because the gain is based on the $10 a share paid with cash and excludes the $10 a share paid with funds borrowed from the broker.

However, if the stock dropped to $15 a share, it becomes a loss of 50%—double what the loss would be if the stock was paid entirely in cash. Moreover, it could lead to a margin call.

As with any loan, when traders buy securities on margin they have to pay back the money borrowed plus interest, which varies by brokerage firm and the amount of the loan. Interest accrues daily at the prevailing rate and is deducted from a trader's account on a monthly basis.

Margin interest rates are typically lower than those on credit cards and unsecured personal loans. There's no set repayment schedule with a margin loan—the principal can be paid down any time. However, there are monthly interest charges that continue to accrue to the account until the principal is paid off. It's important to note, too, that those rates may fluctuate.

Also, margin interest may be tax deductible if used to purchase taxable investments and deductions are itemized (subject to certain limitations; consult a tax professional before proceeding).

As already noted, when used for investing, margin can magnify profits—and losses. While the value of the stocks used as collateral for the margin loan fluctuates with the market, the amount borrowed does not. As a result, if the stocks fall, the equity in the position relative to the size of the margin debt will shrink and could lead to a margin call, increasing the level of market risk.

Traders using margin need to remember that while there's flexibility in paying down the principal of the margin loan, there's no extension of time to meet a margin call.

But margin isn't limited to the long side. Investors with margin privileges can sell stocks short as well, with the aim of making money during, or hedging against, a market decline. Short selling, however, is an advanced trading strategy involving potentially unlimited risks. Consider that when traders buy shares of stock (take a long position), the downside is limited to 100% of the money invested. But when a stock is shorted, its price can keep rising.

In theory, that means there's no upper limit to the dollar amount needed to replace the borrowed shares. It also means there's no guarantee the broker can continue to maintain a short position for any period of time and may close out the position without regard for loss or profit.

For traders and investors who buy and sell frequently, margin can potentially be a handy ally when near-term potential opportunities arise.

Individual investors and traders can apply for a regular margin account with as little as $2,000, but there are rules regarding what's called a "pattern day trader." As defined by FINRA, a pattern day trader is one who executes four or more trades within five consecutive business days in a margin account. These accounts can only open and close a position three times within the same day during that five-day time frame, or else the account will be flagged, and will then need a minimum equity balance of $25,000 or more.

An investor with $25,000 in an account above and beyond any money needed to hold securities, if approved for margin, could have access to $100,000 of day trading buying power. However, if the account's equity drops below the $25,000 minimum for pattern day trading, that account could be subject to a minimum day trading equity call. The image below from the thinkorswim^® trading platform highlights how investors can assess the impact of an individual trade before it's made.

Like the options market itself, trading on margin in options is quite different, and often more complicated and risky than equities.

For "defined-risk" options strategies—like long puts and calls or verticals—margin requirements are relatively straightforward. Margin functions like a cash account inside a "margin" account, meaning an investor simply needs to put the cash up for the cost of long trades. Or, in the case of short strategies, such as short vertical spreads³ or iron condors⁴, investors need to put up the amount at risk.

Short vertical spreads, for example, would require the difference between the strike prices less the net premium received. Remember, if or when investors utilize such strategies, they need to follow the margin rules on the stock or underlying.

For option traders with accounts approved for advanced options strategies who are willing to step further out on the tightrope, it's possible to sell calls or puts "naked," meaning with no hedging position in place to offset any losses.  Margin requirements will vary from broker to broker, usually from 15% to 20% of the underlying value. Keep in mind, however, selling naked options can potentially expose traders to large or unlimited risks.

Much like other traditional loans, margin requires the posting of collateral to backstop the money that's being borrowed. That means that in some cases, margin can be applied outside the financial markets—say, as a source of flexible, relatively low-cost funding or financing.

However, there are unique risks if margin is used for such purposes, as well potential tax implications. Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs. For example, interest expense would typically only be tax deductible if the proceeds of the debt are used to purchase investments, and those investments generate taxable net investment income. Another risk when using margin as financing is the collateral—the securities in an account—could depreciate and trigger a margin call. At that point, the account holder would be required to deposit funds to meet the margin call. In essence, a margin loan could be called in at any time.
 

Whichever investor or trader profile fits, it's important to remember that margin can be a useful tool if applied with prudent risk-management techniques. But it's not to be abused or trifled with. Margin offers a number of potential benefits, but it comes with distinctive risks that should be carefully considered.

Carefully read "The Charles Schwab & Co., Inc. Guide to Margin" for more details.