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Margin Trading: What It Is and How It Works

By Carla Tardi · June 08, 2022 · 9 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

Margin Trading: What It Is and How It Works

Investing can seem like a foreign language sometimes. There are myriad acronyms and much lingo to learn, even if you’ve been at it a while.

There are IRAs, 401(k)s, 403(b)s, stocks, bonds, common stock, preferred stock, index funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and a lot more. And that does not even touch all the ways you can invest, like selling short and fractional sales; or the various order types like limit orders, stop orders, and stop-limit orders.

Then there’s margin trading, which can be confusing because it comes with a lot of rules — and a lot of specialized words and lingo. Maybe you’ve heard of it, maybe the term is wholly new, or maybe you’re thinking about getting into margin trading yourself.

What is margin, actually? How is it different from the way you might be buying stocks, ETFs, index funds, and other investments now? What are the potential benefits? What might some be of the risks associated with margin trading? And how do you get started?

Margin trading might seem a more complicated than some other ways to invest in the stock market, but it’s a method that many investors favor — especially by experienced investors.

What Is Margin Trading?

Margin trading is an advanced investment strategy in which you trade securities using money that you’ve borrowed from your broker to magnify your return. Margin is essentially a loan where you can borrow up to 50% of your security purchase, and as with most loans, a margin loan comes with an interest rate and collateral.

Trading on margin is similar to “buying on credit.” Using margin for a trade is also known as leveraging.

The margin interest rate depends on how much you borrow and your relationship with the broker. Cash and stock are popular forms of collateral typically used by margin traders and are based on the account’s size and type of security being traded. Traders must also maintain a margin balance, known as the maintenance margin, in their accounts to cover potential losses. We cover the topics of interest, maintenance margin, and other details in the section, “How Does Trading on Margin Work?”

Margin trading is a bit more complicated (and risky) than some other ways to invest in the stock market, but it’s a method that numerous traders favor — especially the more experienced ones.

Below, we dive into how using margin is different from other ways of investing. We explore the potential advantages and risks of margin trading, along with the regulations and other ins and outs of margin trading. And, if you feel ready to use this technique, we discuss how to get started.

How Does Trading on Margin Work?

There are different ways to buy stocks, funds, bonds, and other securities. You might buy one share of a company at its full price. You might buy a fractional share, which means you purchase a portion of a share of stock, not the entire share. Or, you might put $10 a week into an ETF that’s comprised of stocks from a particular industry or sector that you like.

Margin trading is a little different from these approaches. Trades are made using some of your money and someone else’s, usually a brokerage firm’s. Here’s how it works.

•   As the investor, you take out a loan from your broker on an investment that you hope will rise in value, with the aim of seeing a return. When you sell the investment, you return the borrowed funds to the broker, and you keep the profits. Or, you may short stocks on margin, in which case you hope that the value declines,

•   For example, say you wanted to buy $5,000 worth of stock in an asset that you believe has had a big year in revenue. You could use $2,500 of your own money. The brokerage firm might lend you $2,500 to make up the difference; so the total investment would be $5,000 for an initial cost to you of only $2,500.

•   To execute such a trade, you’d need to open a margin account with a brokerage firm. The broker, as well as FINRA, generally require a minimum deposit to open a margin account, and the account balance acts as collateral against the loan.

•   In addition, the loan typically includes interest. The person borrowing the money for the margin trade is responsible for the amount owed plus interest. If the stock drops in value, the investor would still be responsible for the $2,500 plus any interest on the loaned amount.

•   On the flip side, if the stock goes up instead of down, and you used a margin account, then your purchasing power and potential could increase.

You can also use a margin account for shorting stock. This means that you sell a security you do not own. An investor can borrow a security, then sell it; then buy it back later for less money. A short-seller is betting on, and profiting from, a drop in a security’s price.

Margin exposes the investor to potentially greater gains or losses and is a riskier way to invest than not using margin.

The Language of Trading on Margin

As we said above, margin trading is slightly different from some other ways to invest; such that, it’s developed its own set of related terms. Before you embark upon margin trading, it might help to familiarize yourself with some of them.

Margin Account

This is the type of brokerage account you’ll need to begin trading on margin. It means the brokerage firm will lend funds for stock purchases.

Financial Industry Regulatory Authority (FINRA)

Financial Industry Regulatory Authority (FINRA) is a nonprofit agency organized by Congress. This organization oversees margin trading by writing and enforcing rules that govern the industry, ensuring brokerage firms’ compliance with those rules, and educating investors. FINRA’s goal is to help protect investors and regulate brokerages to ensure that they’re working in the best interests of American investors.

Minimum Margin

FINRA rules set a dollar amount that must be deposited based on the kind of margin trading to be executed. The amount may vary depending on the purchase amount of the investment and brokerage firm policies. And, it’s possible that brokerages might set higher minimums than FINRA does.

Initial Margin

The initial margin for new accounts is set at 50% by Regulation T of the Federal Reserve Board . Under FINRA rules, this amount must be $2,000 or 100% of the purchase price of the margin securities, whichever is less. This means that a $10,000 trade, for example, would require an initial margin of $5,000. Some brokerages might even ask for more than 50% as part of the initial margin. Keep in mind that this is FINRA’s rule; some brokerages may require a higher minimum margin.

Maintenance Margin

The maintenance margin specifies the amount of money that investors are required to keep in their margin accounts. According to the U.S. Securities and Exchange Commission (SEC), “FINRA rules require this ‘maintenance requirement’ to be at least 25 percent of the total market value of the securities purchased on margin (that is, ‘margin securities’).” This might mean investors might need to add cash to their margin accounts if the price of their investment drops significantly. For short sales, the minimum requirement is $2,000.

Margin Call

A margin call happens when the value of an investor’s margin account dips below the brokerage’s maintenance margin. The “call” is a request for the investor to meet the maintenance margin and usually happens when a security the investor purchased decreases in value. If you get a margin call, you may bring the account up to the minimum amount by depositing more funds, or assets, into the account, or selling off some securities in the account.

Once you’ve familiarized yourself with margin trading lingo and some basic stock market terms, it might be helpful to understand some potential benefits and risks of margin trading.

Potential Benefits of Margin Trading

•   Potential to enhance purchasing power. A primary benefit of margin trading is the potential expansion of an investor’s purchasing power, sometimes exponentially. This could possibly help boost returns if the price of the stock or other investment purchased with a margin trade goes up.

•   Possible lower interest rates. Benefits of margin loans might include lower interest rates — than other types of loans, such as personal loans — and the lack of a set repayment schedule. Margin loans are meant to be used for investing and generally should not be used for other purposes, although they can be.

•   Diversification. You could also use margin trading to diversify your portfolio.

•   Selling short. Another potential advantage might be a complicated trading method called short selling. Margin trading might make it possible for you to sell stocks short. Short selling differs from most other investment strategies in that investors make a bet that a stock’s price will fall.

•   The rules for short selling with a margin account can get even more complicated than a traditional margin trade. For instance, Regulation T of the Federal Reserve Board requires margin accounts to have 150% of the value of the short sale when the trade is initiated.

While the benefits of being able to buy more investments — and potentially make more money — might seem appealing to some investors, there are also some potential risks to using margin. It might be worth considering these before you decide if trading on margin is right for you.

Potential Risks of Margin Trading

•   Possible loss beyond initial investment. While a primary benefit of margin trading may be increased buying power, investors could lose more money than they initially invested. Unlike a cash account, the traditional way to buy stocks or other investments, losses in a margin account can actually extend beyond the initial investment.

   For example, if an investor purchases $20,000 worth of stock with a cash account, the most they can lose is $20,000. If that same investor uses $10,000 of their own money and a margin — essentially a loan — of $10,000 and the stock loses value, they may actually end up owing more money than their initial $10,000.

•   Possibility of margin call. Another potential negative aspect of margin trading is getting a margin call. Investors might need to put additional funds into their account on short notice if a margin call is triggered because the investment lost value. Moreover, a drop in value might mean an investor needs to sell off some or all of the investment, even at an inopportune time.

•   The SEC warns investors that they must sell some of their stock, or deposit more funds to cover a margin call. If you get a margin call, it is your responsibility to deposit more funds, add securities or sell holdings in your account. If you don’t meet the margin call after a number of warnings from your broker, then the broker has the right to sell all or some of the current positions to bring the account back up to minimum value.

How to Get Started With Margin Trading

Typically, the first step to getting started with margin trading is to open a margin account with a brokerage firm.

Even if you already have a stock or investment account, which are cash accounts, you still need to open a margin account because they are regulated differently. First-time margin investors need to deposit at least $2,000 per FINRA rules . If you’re looking to day trade, this dollar figure goes up to $25,000 according to FINRA rules. This is the minimum margin when opening a margin trading account.

FINRA defines a day trade as “the purchase and sale, or the sale and purchase, of the same security on the same day in a margin account.” These higher dollar amounts could be associated with what some have called the “greater risk of day trading.”

Once the margin account has been opened and the minimum margin amount supplied, the SEC advises investors to read the terms of their account to understand how it will work.

The SEC advises investors to protect themselves by

•   Understanding that your broker charges you interest for borrowing money,

•   Knowing how the interest will affect the total return on your investments,

•   Recognizing that not all securities can be purchased on margin,

•   Comprehending the details about how a margin account works, and

•   Being aware of possible outcomes should the price of assets purchased on margin decline.

Does Margin Trading Work for Your Goals?

That’s the question most investors will probably need to answer for themselves once they’ve learned the lingo, weighed the pros and cons, and figured out how margin trading works.

As with most investing strategies and vehicles, margin trading comes with a unique set of potential benefits, risks, and rewards.

Margin trading can seem a little more complicated than some other approaches to investing. As the investor, it is up to you to decide if the potential risks are worth the potential rewards, and if this strategy aligns with your goals for the future.

Want to explore what investing options might work with your goals? Check out automated or active investing with the SoFi Invest investment app today.

See how SoFi margin trading may work for you.

FAQ

What is a margin call?

A margin call occurs when the investor does not keep the minimum amount in their margin account. If the account balance falls below the minimum amount, the broker typically will ask the account owner to deposit more funds, or assets, in the account to meet the minimum requirement.

What is a margin rate?

A margin rate is the interest rate that applies when an investor trade on margin. Margin rates can vary from broker to broker. Many brokerages use a tiered rate schedule based on the amount of the margin loan.

How popular is margin trading?

Margin trading as an investment strategy is not particularly popular; but neither is it unpopular. It’s just risky. Because of the potential risks involved, professional traders tend to use it more than individual investors. And it is generally not recommended for beginners.

What happens if you don’t have the money to meet a margin call?

If you get a margin call, it is your responsibility to deposit more funds into your account. If you don’t meet the margin call after a number of warnings from your broker, then the broker has the right to sell all or some of the current positions to bring the account back up to minimum value.


*Borrow at 5.25%. 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.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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