In this article, you will find answers to common questions, such as:
- What does margin mean in the share market?
- What is meant by margin money?
- What is margin requirement?
- What is margin trading and what are its examples?
Overall, this article will explain the meaning of margin and margin trading. You can also find information here about the risks of trading on margin and the many benefits and disadvantages that you can expect if you are planning to trade on margin in the stock market.
What Is Margin?
Stock market investors sometimes borrow cash from brokers to improve their purchasing power. They use the borrowed cash to buy stocks or any type of financial instrument. While it can be beneficial for them, it also puts them at higher credit risk. To protect themselves from the losses that may be incurred by investors in the money they borrowed, the brokers often ask for a collateral in exchange for the borrowed funds. In stock market terms, this collateral is called “margin”.
In the general business concept, margin refers to the ratio of profit to revenue. It is the difference between the production cost of a product or service and its selling price. In home loans, it refers to the portion of the interest rate added to a home loan with an adjustable-rate mortgage (ARM).
Key Points to Remember:
- Margin is the funds borrowed by an investor from a broker to allow him to purchase more investments.
- Margin trading is an act where an investor borrows funds from the broker in order to trade a financial asset.
- A margin account is a standard brokerage account that allows investors to use the current cash or securities in their accounts as collateral for loans made with the broker.
- Leverage gained by margin can likely increase both gains and losses. When a loss occurs, a margin call may be done, and the broker may liquidate all the securities of the investor without prior consent.
Understanding Margin and Margin Trading
The amount of equity found in an investor’s brokerage account is referred to as margin. When the investor buys securities using this amount or when he purchases assets using money borrowed from the broker, this is called “buying on margin” or “to margin”. To do this, an investor first has to have a margin account instead of just a regular brokerage account. A margin account is essentially a brokerage account that allows the investor to borrow funds from the broker and use these funds to purchase assets that they could not possibly do with just the balance they have in their accounts.
When you purchase securities using margin, it is like putting in the existing cash you have in your account as collateral for a loan. Like any other loan, this will incur periodic interest rates, which you will eventually have to pay. Since you are using borrowed money, you can expect your losses and gains to multiply. Margin trading is beneficial only when investors earn more ROI than the interest they are paying on the margin.
Important: According to the Securities and Exchange Commission, margin accounts may not be for everyone as they are very risky.
Buying on Margin
Buying on margin is an act where an investor borrows money from a broker so that he or she can purchase more stocks. In other words, it is a loan that an investor gets from a broker. With margin trading, you will be able to purchase more stocks. If you are planning to trade on margin, though, you should first open a margin account. A margin account is different from a standard cash account, as a the latter only allows you to trade using only the cash available in your account.
One of the requirements you need to comply in order to open a margin account is to deposit an initial amount of at least $2,000. This amount can vary depending on the brokerage. Some brokers may require more. This initial deposit is called the minimum margin. All brokers are required by law to obtain your consent first before they can open a margin account on your behalf. They may either ask you to sign a separate agreement for this or they may include this in the standard account opening agreement.
Initial margin refers to the purchase price percentage that you initially deposited upon account opening. Once the account is active, you can then borrow up to 50% of a stock’s purchase price. You can borrow less than this percentage, but you cannot exceed the 50% benchmark. Some brokerages may also require you to deposit more than 50% of the stock’s purchase price.
There is no limit as to how long you wish to keep your loan. What is important is that you are able to pay the interests on time and you do not default on other obligations related to the loan. Each time you make a sale on the stocks on your margin account, the money goes directly to the broker and will be considered as payment to your existing loan. This process will continue until you have fully paid your loan.
Maintenance Margin and Margin Call
Margin accounts require a minimum account balance that must be maintained to keep your loan in good standing. This minimum account balance is called maintenance margin. Currently, minimum account balance is set at 25% of the entire securities value in a margin account. If the minimum account balance falls under this percentage, a margin call may occur. Margin call refers to the process by which your broker may force you to sell some of your stocks or to deposit more funds into your account so that you can pay down your loan. If you cannot meet the requirements of the margin call, the brokerage may choose to liquidate open positions in your account without your approval so that your account will get back to its minimum value. The brokerage may also charge a commission for the transaction. Moreover, the broker may choose to liquidate more contracts or shares and exceed the initial margin requirement.
You will be responsible for all the losses that will be incurred during a margin call.
Note that using margin money in the stock market comes with risks. All the marginable securities that you have in your account can be considered collateral and you can lose all of them once you fail to pay off your loan. Using the margin money can make you incur interests, which you will have to pay apart from the principal amount of your loan. If you cannot pay off your loan immediately, interest charges can pile up and you could wallow in debts. As such, if you plan to use margin money, make sure to use it only for short investments. The more you hold an investment bought from margin, the less you are likely to earn a profit.
It is worth noting as well that not all types of securities may be bought using margin. The Federal Reserve Board prohibits the purchase of penny stocks or stocks or stocks that can be bought at $5 per share. It also prohibits the purchase of initial public offerings (IPOs) and over-the-counter Bulletin Board (OTCBB) securities. This is because of the risks involved in these types of stocks. Certain brokerage firms may also choose not to sell certain stocks on margin, so it is recommended to check the restrictions agreement on your margin account first if you plan on purchasing securities using margin.
Significant margin calls on certain investors may also affect other stakeholders. For instance, if an investor faces a forced liquidation due to a significant margin call, the value of the securities held as collateral by other investors could also decrease. In this process, these investors could possibly undergo a margin call as well.
Advantages of Margin Trading
Many investors resort to margin trading because of the leverage that this type of trading offers. Margin trading helps investors to raise capital and improve their purchasing power, allowing them to purchase more securities than they could with their own funds alone. The more securities they can purchase, the better chances they have of earning higher profits.
Another advantage of margin trading is that it is more flexible compared to other types of loans. Investors are not bound to a strict repayment schedule and brokers often have simple or automated margin requirements. Some brokers also allow the loans to be open until the investor is able to sell all the securities and make the final payments.
Disadvantages of Margin
Margin trading may offer certain advantages, but investors who want to go this route for the primary purpose of gaining more profits should be aware that they could also incur huge losses in the process. For instance, when the value of securities bought on margin declines, the investor may not only lose his investment capital but also sustain huge debts to his lenders. Margin trading is risky; investors can incur high interest charges which can pile up rapidly. Interest expenses are assessed by brokers regardless of whether the investor’s margin account is performing well or poorly.
Another disadvantage of margin trading is that investors could face a margin call once they are not able to meet the margin and equity requirements. Investors are required to deposit more funds into their margin account if the equity of the securities they hold decrease in value. Investors must be ready to meet the additional capital required in order to satisfy a margin call. If the investors are not able to put in additional capital as required and margin requirements are not met leading to rapid decrease in the value of the account, the broker can choose to perform a forced liquidation. Such a move by the broker could lead to huge losses in the part of the investors.
In summary, the advantages and disadvantages of margin trading are the following.
- Investors gain leverage and may enjoy greater profits
- Enhances an investor’s purchasing power
- More flexible compared to other loan types
- Provides investors increased leverage opportunities once their collateral value increases
- Can lead to greater losses
- Can incur account fees and interest expenses
- Can lead to margin calls which require investors to put in additional equity investments
- Can lead to forced liquidations, leading to investors suffer from more losses
Example of Margin
To give you a better picture of what margin and margin trading are, below is an example that simplifies the concept.
Let us say, for example, that you deposited $20,000 in your margin account, which is 50% of the purchase price. This means that you already have a purchasing power of $40,000. You use $5,000 of this amount to purchase some stocks, leaving your account to have $35,000 remaining balance. You have enough money to cover the expenses of your transaction without tapping into your margin yet. You bought other securities worth more than $25,000. In this case, you are now trading using borrowed money since you have exceeded the amount you have deposited in your account.
Note that the buying power of your margin account can differ from day to day depending on the movement or changes of prices of marginable securities in the market.
Other Uses of Margin
In business accounting, margin is referred to as the difference between expenses incurred and profits gained. It is the practice of businesses to track all their monetary transactions, including operating expenses, gross profit margins, and their net profit margins. Operating expenses, also known as operating profit margins, is the sum of the cost of goods (COGS) and all other expenses incurred from operations. Gross profit margin measures the total revenue gained after all expenses or operational costs are subtracted from the total amount. Net profit margin, on the other hand, is gained after all expenses, taxes, and interests are computed.
Margin in Mortgage Lending
In home loans, such as in adjustable-rate mortgages, a fixed interest rate is given for introductory periods. When this period expires, the rate is then adjusted. To determine the new rate, the bank usually adds a margin on established benchmarks. Most of the time, the margin does not change throughout the duration of the loan, but the benchmark or index rate usually fluctuates. For example, an adjustable-rate mortgage indexed in the Treasury Index has a 4% margin. The Treasury Index rate is 6%. The total interest rate of the mortgage, therefore, becomes 10%, since it is computed as the sum of the index rate and the margin rate.
What Does It Mean to Trade on Margin?
Margin trading in the share market generally refers to the process wherein an investor borrows money from the broker in order to perform trades in the stock market. When margin stock trading, the investors are required to first deposit an amount into their margin account. The deposits will serve as collateral for the loans used by the investors in margin trading. The investors will then start paying interest rates on the borrowed money they are using. The loan helps the investors to gain more purchasing power, allowing them to buy more securities. The securities purchased become collateral for the margin loan automatically.
What Is a Margin Call?
A margin call is a situation wherein the broker demands to increase the collateral amount contained in the investor’s margin account. This usually happens when the account falls below the required maintaining value. When an investor is faced with a margin call, he or she must sell securities or put additional deposits into the account to meet the broker’s margin requirement. If the investor fails to do so, the broker reserves the right to liquidate the investor’s positions without prior consent from the investor. This is done to raise the necessary amount needed to meet the margin requirements. Margin calls are feared by investors because these can force them to sell their positions at extremely low prices, leading to more losses.
What Are Some Other Meanings of the Term Margin?
We may already have answered the questions “What is margin?” and “margin stock”, but margin has other meanings outside of the stock market. The term is also used in other aspects of finance. In fact, it is used as a blanket term that refer to various other types of profit margins, such as net profit margin, gross profit margin, and pre-tax profit margin. Sometimes, it is also used to refer to risk premiums or interest rates.
What Are the Risks of Trading on Margin?
Margin trading is extremely risky. The value of securities can go down rapidly, leading investors to either add more funds into their margin accounts or to sell some of their securities at lower rates. This means that investors have higher risks of losing more than what they have deposited in their accounts.
As an investor in the stock market, you may want to consider adding margin trading in your portfolio. Margin trading allows you to buy more securities using borrowed funds from the broker. Since you can borrow money to buy securities, you gain more purchasing power and higher chances of earning better profits. Margin trading, however, comes with high risks. The value of the securities in your margin account can decline and you may lose your collateral and more of your funds in the process.