Margin debt is the amount that traders borrow from stock brokers when they want to trade on margin, or buy securities such as stocks or exchange-traded funds (ETFs) using leverage. It is not available on a cash-only account, in which a trader simply buys the stock they want and they cover the full amount using the cash in their account.
Leverage means that a trader buys more shares than the cash value of their account, and they borrow the remainder of the money from their broker using a margin account. The amount that they borrow from the broker is known as margin debt, and the amount that they pay in cash is known as the equity.
Debt margin trading gives the investor the opportunity to earn significant profits, beyond what they could earn if they only bought securities with cash they have on hand. But it also opens up the trader to larger risks of losses, because if the stock decreases in value they will be in margin debt and on the hook to pay for the difference between the cash they deposited and the amount the stock went down. Traders also have to pay additional fees and interest on any money they borrow from a broker for a margin trade.
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Margin Debt Definition
When engaging in margin trading, an investor could potentially borrow up to 100% of the cash they have in their account, allowing them to buy twice as much stock. This would mean they are 200% invested, or fully margined. Government regulations and brokerage rules, however, may limit the amount of margin to which a specific investor has access.
How Margin Debt Works
Traders can use margin debt for both long and short selling stocks. The Federal Reserve Board’s Regulation T places limitations on the amount that a trader can borrow for margin trades. Currently the limit is 50% of the initial investment the trader makes. This is known as the initial margin. In addition to federal regulations, brokerages also have their own rules and limitations on margin trades, which tend to be stricter than federal regulations. Brokers and governments place restrictions on margin trades because they are very risky but also because they can result in significant gains.
Example of Margin Debt
A trader wants to purchase 2,000 shares of Company ABC for $100 per share. They only want to put down a portion of the $200,000 that this trade would cost. Due to federal regulations, the trader would only be allowed to borrow up to 50% of the initial investment, so $100,000. In addition to this regulation, the broker might have additional rules. So the trader would need to deposit at least $100,000 into their account in order to enter the trade, and they would be taking on $100,000 in debt. The $100,000 in their account would act as collateral for the loan.
The broker may also require that the trader keeps a certain amount of cash in their account at all times for the duration of the trade. In the case that the value of the stock goes down, the trader will owe the broker money, and they will either have to deposit cash or sell some of their holdings.
An investor can keep margin debt and just pay off the margin interest until the stock in which they invested increases to be able to pay off the debt amount. The brokerage typically takes the interest out of the trader’s account automatically. In order for the investor to earn a profit or break even, the interest rate has to be less than the growth rate of the stock.
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Advantages and Disadvantages of Margin Debt
There are several benefits and drawbacks of margin debt to purchase securities such as stocks or exchange-traded funds.
Advantages
• Margin trading allows a trader to purchase more securities than they have the cash for, which can lead to significant profits. The trader can use the cash they have to enter more trades and create more opportunities to profit.
• Traders can also use margin debt to short sell a stock. They can borrow the stock and sell it, and then buy it back later at a lower price.
• Traders using margin can more easily spread out their available cash into multiple investments.
• Rather than selling stocks, which can trigger taxable events or impact their investing strategy, traders can remain invested and borrow funds for other investments.
Disadvantages
• Margin trading is risky and can lead to significant losses, making it less suitable for beginner investors.
• The investor has to pay interest on the loan.
• If a trader’s account falls below the required maintenance margin, such as because the stock drops in value, that might trigger a margin call. In this case the trader will have to deposit more money into their account or sell off some of their holdings. If a stock is very volatile, this can increase a trader’s debt and result in a margin call.
• Brokers have a right to sell off a trader’s holdings without notifying the trader in order to maintain a certain balance in the trader’s account.
Is High Margin Debt a Market Indicator?
Stock market margin debt recently reached an all-time high, which leaves some traders wondering whether what that means for the markets or their investing strategies.
Some traders view margin debt as one measure of investor confidence in the markets. So, high margin debt can be an indicator that the market is near the top, but this is not always the case. It can be helpful for investors to look at whether total margin debt has been increasing year over year, rather than focusing on current margin debt levels. The Financial Industry Regulatory Authority (FINRA) publishes total margin debt levels.
There have been several instances in the past 50 years where year-over-year changes in total margin debt followed significant market runs and marked near the top of the market.
• May 5, 1972: Margin debt up 55.8% year over year.
• Dec. 3, 1999: Margin debt up 58.9%.
• June 1, 2007: Margin debt up 67.5%
However, there have also been circumstances in which large increases in total margin debt did not indicate the peak of the market. So jumps in margin debt do not always indicate a coming market drop, while they may be an indication to keep an eye out for additional signs of market shifts.
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The Takeaway
Margin trading can be a useful tool for trading, but it isn’t recommended for beginning traders due to its high risk level. It also may not be the best strategy for investors with a low appetite for risk, who should likely look for safer investment strategies.
If you do have the experience and the risk tolerance to try out trading on margin, SoFi can help. With a SoFi margin account, you can increase your buying power, take advantage of more investment opportunities, and potentially increase your returns.
Photo credit: iStock/PeopleImages
*Borrow at 7.00%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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