What is margin trading? 6 things to know before you trade

In your search for the right investment strategy, you might’ve come across margin trading at some point. But what is margin trading? And is it something you should be taking advantage of?

Margin trading, which is also referred to as buying investments on margin or margin investing, has to do with how you trade, not what you trade, and it can offer  DIY investors  more trading flexibility.

Sounds great, right? Here’s the catch.

You can also lose more than the entire amount you invested in a relatively short period of time when trading on margin. That’s why it’s so important to proceed with caution. Even confident traders can misjudge an opportunity and lose money.

Before you dive into margin trading, here are a few things to know about this advanced investing technique (which is sometimes used by day traders).

A margin account isn’t a type of investment security, like a stock, mutual fund or bond. It’s money you borrow to invest in a particular security that’s traded on the stock market. It’s similar to getting a mortgage to buy a home, only you’re getting a margin loan from your brokerage to buy stocks.

Your brokerage can decide what securities can be traded on margin, what amount you can borrow with a margin loan and what the margin requirement is (the percent of securities you must pay for yourself). Under Federal Reserve Regulation T, it’s possible to borrow up to 50 percent of a stock or exchange-traded fund’s (ETF) purchase price, although the amount can vary for individual investments. This is what’s referred to as initial margin.

You’ll first need to sign a margin agreement and set up a margin trading account with your brokerage. This is different from an everyday cash account that you’d use to trade other investments on the market.

From there, you make an initial cash deposit in your margin account. The minimum deposit required by Regulation T (which was established by the Board of Governors of the Federal Reserve System to provide rules for extensions of credit by brokers and dealers and to regulate cash accounts) is $2,000 in cash, although you can deposit more. Then, you can get your first margin loan.

Say you have $10,000 in your margin brokerage account and you want to borrow up to the full 50 percent limit of a stock’s purchase price allowed under Regulation T. In that scenario, you could buy $20,000 worth of stock. That total includes $10,000 of your own money, plus $10,000 you borrow from the brokerage.

Margin investing increases your buying power (a.k.a. the money you have available to purchase securities) because you’re not using solely your own money. Essentially, you’re borrowing from the brokerage on the assumption that the price of the stock you’re purchasing will rise, plus you also need margin to short stocks. Keep in mind, however, that you don’t have to trade on margin at the 50 percent mark; you could opt for a smaller loan of 10 or 20 percent instead.

Once you begin to accumulate some marginable securities in your margin account, you can leverage those assets for additional margin loans. Instead of adding more cash to the pile, you can use the value of those stocks as collateral to purchase additional shares on margin.

First, with a margin trade, you’re not tying up all of your investable dollars the way you would with a cash account. That could potentially result in a higher ratio of returns to initial investment.

Let’s look at an example using some nice round numbers: Say you invest $10,000 in cash to buy 100 shares of a $100 stock. If that stock increases 50 percent in value in the next six months, your investment would be worth $15,000.

A lower initial cash investment also gives you the flexibility to diversify into other investments in your trading account, and increased diversification may help provide insulation against risk. Having more cash on hand to trade also means you’re not forced to liquidate other investments to buy additional shares.

The risks and drawbacks should be carefully considered before trading on margin. For one thing, if the stock you’ve invested in as a margin trader sees a sharp drop-off in value, you could lose more than the amount you deposited in your margin account.

Let’s refer to the example in the previous section. If that $100 stock you purchased loses three-quarters of its value, your 200 shares will drop in value from $20,000 to $5,000. In this instance, your account’s equity could be too low and you may receive a margin call to cover the margin deficiency.

Worst-case scenario? Your brokerage may sell all of your shares to fulfill a margin call, meaning a total loss of your initial investment. And if there’s a shortfall in the account, you’ll be on the hook for making it up.

It’s also worth noting that a brokerage may increase its account maintenance margin requirement at any point without notice. If this happens, you might need to deposit more money into your account. Or you’ll be issued a margin call and some (or all) of your holdings could be sold.

A margin call (i.e. a maintenance call) is when your brokerage asks you to add more cash to your margin account because your account value drops. This can happen immediately after your account’s equity value falls below a certain threshold, due to a decline in stock price.

Brokerages typically require a baseline of 25 percent (the industry requirement for a long margin account), meaning you must have at least 25 percent equity of the total market value of the securities in your account.  Ally Invest  has a minimum maintenance level of 30 percent, but some firms have a threshold as high as 40 percent.

Your brokerage isn’t required to notify you of a margin call, although many will try to contact you by phone or email. And they don’t have to give you time to add money to your account, but some might. If you don’t respond to a margin call by making a deposit, your brokerage is permitted to sell the shares of its choosing in your margin account to make up the difference.

The possibility of losing money quickly as a result of a margin call makes margin trading something to consider carefully. Margin borrowing is something  self-directed traders  might be inclined to do, but it may not be the best choice if you are a newer investor or rely on specialists to  manage your investment portfolio for you.

You can’t eliminate risk entirely with margin trading but to limit it, you might consider margin trading as a short-term strategy only. It may help you capitalize on short-term stock gains while keeping the amount of margin interest you pay on the borrowed money to a minimum.

Second, you might avoid putting all your eggs in one basket. Diversify your margin trades with multiple stocks spread across different sectors or invest in exchange-traded funds or mutual funds that offer streamlined diversification.

Last and perhaps most importantly, think about having a margin trading strategy that acknowledges your risk tolerance. It might be helpful to establish your personal tipping point for acceptable losses and consider setting a higher maintenance margin for yourself to avoid margin calls. And maybe keep additional cash or liquid investments in reserve to handle margin calls and monitor your account regularly for potential trouble spots. You might even consider setting a personal initial margin requirement that’s higher than what your brokerage requires.

If you’ve weighed the positives and potential risks of trading on margin and consider yourself ready to invest,  Ally Invest  offers margin trading for self-directed investors.

Trading on margin involves risk. You can lose more funds than you deposit in a margin account. Please review Margin Account Agreement and Disclosure (PDF) for more information regarding margin trading.