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Margin Trading: What It Is and How It Works

By Carla Tardi · December 14, 2022 · 11 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

When it comes to trading and investing, margin is the borrowed money that some traders use to execute their strategy. Buying assets on margin can help magnify your gains and returns—but it can do the same with your losses.

When you buy on margin, you’re purchasing assets using money that you borrow from your broker. Read on to learn more about what it means to trade on margin, the definition of margin trading, and how buying on margin works.

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, or “buying on margin,” 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 Margin Trading Work?

While margin trading seems straightforward, it’s important to understand all the parameters. For all trades, your broker acts as the intermediary between your account and your counterparty.

Whenever you enter a buy or sell trade on your account, your broker electronically executes that trade with a counterparty in the market, and transfers that security into/out of your account once the transaction is completed.

To execute trades for a standard cash account vs. margin account, your broker directly withdraws funds for a cash trade. Thus every cash trade is secured 100% by money you’ve already deposited, entailing no risk to your broker.

By contrast, with margin accounts part of each trade is secured by cash, known as the initial margin, while the rest is covered with funds you borrow from your broker.

Consequently, while margin trading affords you more buying power than you could otherwise achieve with cash alone, the additional risk means that you’ll always need to maintain a minimum level of collateral to meet margin requirements.

While margin requirements can vary by broker, we’ve defined and outlined the minimums mandated by financial regulators.

Term

Amount

Definition

Minimum margin $2,000 Amount you need to deposit to open a new margin account
Initial margin 50% Percentage of a security purchase that needs to be funded by cash
Maintenance margin 25% Percentage of your holdings that needs to be covered by equity

Increase your buying power with a margin loan from SoFi.

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*For full margin details, see terms.

Margin Trading Example

To illustrate how margin trading works, we’ve illustrated an example below.

Imagine you open a margin account with $2,000 at a brokerage firm.

You have a high conviction bet on a stock that’s trading at $200 per share in this example. With $2,000 cash, normally you would only be able to buy 10 shares at the current market price.

However, with your margin account’s 50% initial margin requirement, you’re able to obtain a $2,000 margin loan on top of your $2,000 cash investment, which boosts your buying power to $4,000. This allows you to double your purchase to 20 shares.

Your position breakdown is as follows:

•   $4,000 market value (20 shares); financed with $2,000 cash equity and a $2,000 margin loan.

Use the following formula to calculate your equity value:

E = MV – L

Where,

E = Equity value

MV = Market Value of holdings = Stock price X Number of Shares

L = amount of Margin Loan

Using the formula above, after substituting $4,000 for market value and $2,000 for the margin loan, we get the following.

E = $4,000 – $2,000

E = $2,000, which is equal to the amount of cash equity you contributed at purchase.

Now, assuming a year has passed since you purchased the stock, gains or losses can be calculated as follows.

Calculating Gain

If the value of the stock were to increase to $250 after one year, the market value of the 20 shares you purchased would rise to 20 shares X $250 = $5,000. Your position breakdown would be:

•   $5,000 market value (20 shares)

•   Equity value rises from $2,000 to $3,000

•   Margin loan balance remains $2,000

$3,000 equity after one year – $2,000 initial investment = $1,000 gain on investment

Gain / Initial investment = return

$1,000 / $2,000 = 50% one year return.

Calculating Loss

In the converse scenario, let’s say the value of the stock in this example declines to $150 after one year, the market value of the 20 shares you purchased would drop to 20 shares X $150 = $3,000. Your position breakdown would be:

•   $3,000 market value (20 shares X $150)

•   Equity value drops from $2,000 to $1,000

•   Margin loan balance remains $2,000

$1,000 equity after one year – $2,000 initial investment = – $1,000 loss

-$1,000 / $2,000 = – 50% one year return on investment.

In both scenarios, the margin loan balance remains the same, while the equity value took the entire gain or loss. This is because the investor remains on the hook for the margin loan regardless of whether they gain or lose on the trade.

Bear in mind our example ignores interest expense for simplicity. In a real margin trade, you would need to also back out any interest expense incurred on the margin loan before calculating your return; this would act as an additional drag on earnings.

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.

If you are an experienced trader and have 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.

Get one of the most competitive margin loan rates with SoFi, 7.00%*

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 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.
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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