What Does Trading on Margin Mean & How Does It Work?

Margin trading involves borrowing money from a brokerage firm to purchase securities. This practice allows investors to acquire more assets than they could with only their available cash, using their existing cash or securities as collateral. This method can significantly increase an investor’s purchasing power within the market.

Fundamentals of Margin Trading

Margin trading involves taking out a loan from a broker, with the purchased securities serving as collateral. This borrowed capital, combined with the investor’s own funds, creates a larger pool of money for trading. This amplification of purchasing power is known as leverage, which can magnify both potential gains and losses. For example, an investor with $5,000 can control $10,000 worth of securities if the broker lends an additional $5,000.

While securities are held in a margin account, the investor retains ownership rights, subject to the broker’s lien. Interest is charged on the borrowed amount, accruing on the outstanding loan balance as an additional cost. This interest can vary by broker and is influenced by prevailing rates and loan terms.

Key Margin Account Concepts

Investors must meet specific financial requirements for margin trading. The initial margin is the percentage of the purchase price an investor must pay with their own money. For stocks, Regulation T mandates this initial margin at 50% of the purchase price, though brokerages may require a higher percentage. For instance, to buy $10,000 worth of stock, an investor needs to provide $5,000 of their own capital, borrowing the remaining $5,000.

Once a position is established, the maintenance margin represents the minimum equity an investor must maintain in their margin account relative to the total value of the securities. The Financial Industry Regulatory Authority (FINRA) requires a minimum maintenance margin of 25% of the total value. Brokerage firms often set higher requirements, typically 30% to 40%. For example, if an investor holds $10,000 in securities with a 25% maintenance margin, they must maintain at least $2,500 in equity.

Interest is continually charged on borrowed funds in a margin account. This interest is typically calculated daily based on the settled margin debit balance and is often posted to the account monthly. Annual interest rates for margin loans vary significantly among brokerages and may be tied to a benchmark rate plus a spread, with larger borrowed amounts sometimes qualifying for lower rates.

Opening a Margin Account

Opening a margin account requires meeting eligibility requirements set by regulators and brokerage firms. Investors typically need to deposit a minimum of $2,000 in cash or marginable securities, though some firms require higher amounts. The brokerage assesses the applicant’s financial situation, investment experience, and risk tolerance before approval.

The application process requires signing a margin agreement. This document outlines the terms of the margin loan, including interest rates and the brokerage’s right to issue margin calls and liquidate positions. Once approved, the account provides access to borrowed funds.

Understanding Margin Calls and Liquidation

A margin call is a demand from the brokerage for the investor to deposit additional funds or securities into their margin account. This occurs when account equity falls below the maintenance margin requirement, often due to a significant drop in the market value of securities.

To rectify the deficiency, the investor can deposit additional cash, transfer more marginable securities into the account, or sell some existing securities to restore required equity. Acting quickly is important, as brokerages typically provide only a few days to meet the call.

If the margin call is not met, the brokerage has the right to sell securities in the account without prior notice. This forced liquidation protects the broker’s loan and can occur regardless of the investor’s preferences or market price, potentially leading to substantial losses. The investor remains responsible for any debit balance still owed.