The trading turmoil in January at Robinhood has shone a spotlight on margin trading. While articles have been mostly negative, many people still don’t understand enough about how margin works to make an informed decision.
What is margin investing?
Margin investing is a way to purchase securities in your brokerage account by borrowing money from the broker. Your collateral for this loan is any cash you have in the brokerage account plus the value of your investments. Naturally, the broker charges periodic interest for you to use their money. No matter if your stock advances or declines in price, you’re expected to pay off the loan in full.
Opening a margin account
When you open an E-trade or Fidelity account, you are opening a cash account. Unless you signed up for a margin account with the initial application, you must complete a form to open a margin account and invest at least $2,000 in your account in cash or securities.
Borrowing limits
You can borrow up to 50% of the total purchase price for most investments (this amount can vary depending on the type of investment). So if you want to purchase $5,000 of Stock A, you can borrow $2,500 and use $2,500 of your own funds. Most people don’t borrow up to the limit to leave some wiggle room in case their investment declines in price (which could result in a margin call – more on that later).
In addition to borrowing limits, margin accounts may be limited in other ways. You cannot use margin in a retirement or custodial account. Most investments can be traded in a margin account, but oftentimes stocks must have a sell price of at least $5 per share. Some exotic or ultra-risky securities cannot be traded in a margin account. And as noted above, you must have $2,000 invested in your account.
Cost of borrowing
For most brokerage margin accounts, the interest rate you’re charged will vary depending on the amount you borrow. And these rates aren’t as low as the mortgage rates you see bandied about in newspapers. For instance, a recent (March 2021) glance at E-trade showed their margin rate at 8.95% for a debit balance under $10,000, dropping to 5.45% for a balance of $1 million or more. Similarly, at Fidelity rates were 8.325% (under $25,000) to 4.00% (balances $1 million and above).
Some apps have monthly charges with lower rates for access to margin investing. Robinhood charges $5 for their Robinhood Gold account, which includes the first $1,000 in margin. For any amount above that, you are charged 2.5% (plus the $5 account fee).
Note that you aren’t required to repay the loan on any set schedule. You won’t hear monthly from the brokerage to pay off a portion of the loan like with a mortgage or car loan. Also, companies mentioned here are just for example purposes. I don’t receive money from any – use whatever brokerage works best for you.
Maintenance requirement
The Federal Government requires that investors maintain a 25% equity level in their margin accounts. This is best explained with an example. You purchase $5,000 of Company A when shares are $10 per share, giving you 500 shares. You borrowed $2,500 to make the purchase, so you are at the 50% margin limit. Let’s say these shares drop to $7 per share. Your total investment is now worth $3,500. The maintenance requirement is $875 ($3,500 X .25%). Since the equity of your account is still $1,000 (the $3,500 value of your investments less the $2,500 loan), you’re above the maintenance requirement. However if your investment drops to $5 per share, your equity is $0 ($2,500 in securities less $2,500 loan) while the maintenance requirement is $625. In this case, you may receive a margin call from your brokerage.
While the federal maintenance requirement is 25%, brokerages may require larger margin minimums – as much as 30% to 40%. Make sure you understand this before opening an account. Additionally, a brokerage can change this minimum at any time.
Margin call
If you fall below the maintenance requirement, the brokerage may issue a margin call, which will require you to either deposit cash or sell securities to bring your account up to the minimum. The broker also has the right to sell securities in your account, sometimes even without contacting you. In fact, if you cannot meet the margin requirements, your brokerage can sell all your shares with the possibility that you still owe them money if those sales don’t cover the maintenance minimum.
Why use margin?
Enhanced returns. Let’s revisit the example above. But instead of the stock dropping in value, it increases to $20 per share. Your 500 shares are now worth $10,000. So you’ve seen a 100% return, right?
Actually, it’s better than that. Your initial investment was $2,500 and you borrowed $2,500. When you pay back the $2,500 margin loan, you’re left with $7,500 (not counting margin interest). You’ve tripled your money. If you had made the same trades with a cash account, you would have doubled your money and had more of your money tied up in this one investment.
Margin loan flexibility. As noted above, you don’t have to pay off your margin loan on a specific schedule. While the rates are higher than a mortgage or competitive car loan, they are much lower than credit card interest rates. Some people use margin loans for consumer purchases due to this flexibility. If you choose to do this, remember to keep the equity in your margin account above the required minimum.
While not a reason to start using margin, you might be able to write off your margin interest as an itemized deduction. Check with your tax advisor for more information.
Why not use margin?
Enhanced losses. Just as margin investing can provide amplified returns, it can also result in heightened losses. We went through the example where the investor would have to pony up $625 after a margin call. Imagine that she does this, only to see the stock drop more in the coming months. Or worse, it goes up a little to provide more confidence, then tanks again. Every time you go below the maintenance level, you can be forced to provide more cash or sell stocks. And it doesn’t end until you pay back in full (with interest) your loan. In a worst case scenario, you could lose much more than you initially invested.
Let’s also compare it to a cash account. You purchased $5,000 of Company A (50% margin) at $10 per share like in the example above, but the price dropped to $7 and you sold. You receive $3,500, pay back $2,500 (not counting interest payments on the loan), and are left with a loss of $1,500.
If you had invested $2,500 (your cash amount) in the same investment and sold at the same time, you would have received $1,750, making your loss $750. You would have lost half of what it would have been versus using margin.
Margin calls. As noted above, most brokerages will attempt to contact you if there’s a margin call. However, they don’t have to and can sell your stocks however they see fit. You won’t have extra time to come up with the money and won’t be able to pick and choose what they sell.
Margin is best suited for experienced investors. If you choose to try this, consider starting with a small percentage of your total portfolio in a margin account. People who have shown a history of mismanaging loans (repeatedly maxing out credit cards and only paying minimums, for example) or who see margin investing as gambling probably should stay away. Margin can work in your favor, but you’ll need a disciplined approach to make sure it doesn’t get out of hand.
Photo by Clay Banks