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How Stock Margin Works – The Basics

To continue on with my buying and selling stocks for beginners series, lets get into the basics of how stock margin and margin accounts work.

When the application to open a discount brokerage account is initiated, there is a choice of whether to open a margin or cash account.  I typically open a margin account because, one, I understand how it works (for the most part), and second, it’s the same as a cash account except that you have the “option” of borrowing from the brokerage. The ability to borrow from the brokerage also opens the door to shorting a stock and buying/selling options if the investor chooses.

How does a margin account work?

Margin accounts are identical to cash only accounts except that they have the ability to go into a negative balance. Once the account goes into the negative range, the brokerage will charge you interest at their margin rates.

Some of the more trader friendly discount brokerages, like Interactive Brokers, have margin rates below prime which makes it an ideal choice for leveraged equity investing.

How does buying stock on margin work?

The term margin represents the investors equity in the trade. When we say that 50% of the stock is marginable, that basically represents that the investor needs at least 50% equity in the trade.

Not every stock on the market is available to be purchased on margin. For equities, the trader can typically margin up to 50% of the total value of the trade providing that the stock is above $2 and is a marginable security. Securities that are less than $2 in value have a higher margin requirement.

Some of the larger, higher volume stocks on the exchange are eligible for reduced margin (30%) which means that the investor can borrow up to 70%. Here’s a list of securities eligible for reduced margin as indicated by Interactive Brokers.

For Example:

  • Share Price: $10 (assume eligible for reduced margin)
  • Purchase Amount: $10 x 100 shares = $1000
  • 30% margin = $300 minimum equity required and maintained, $700 borrowed.
  • Interest rate = 5%

Case 1 – The Ideal Situation: After 1 year, shares rise to $12 and sold

  • Value: $12 x 100 shares = $1200
  • – purchase cost ($1000) – interest cost incurred ($35) = $165 profit
  • 55% gain with margin/leverage, 20% gain without.

Case 2 – The Dreaded Margin Call: After 1 year, shares drop to $8

  • Value: $8 x 100 shares = $800
  • $800 – borrowed amount ($700) = $100 which is $200 less than the $300 (equity) required to be maintained. This will result in a margin call (see below) which will require $200 to be deposited into the account immediately. The choice is either to sell the security or deposit the minimum of $200.

Margin Calls

As you can see from Case 2, there was a margin call. Margin calls occur when margin is used and the investment value falls below the margin requirement. When this happens, there is one of two things that has to happen to get the account back to acceptable levels.

  1. The investor can deposit cash into the account to eliminate the deficit.
  2. If the cash does not arrive within the specified time indicated by the brokerage, then the brokerage has the right to liquidate securities until they get their money back.

Final Thoughts

Margin is simply a fancy word for leverage. However, borrowing with margin is different than using a loan or line of credit to invest with. First, the money is borrowed directly from the brokerage and second, if the investments purchased with margin decrease in value, the brokerage has the right to sell those securities without warning (margin call).

To avoid the dreaded margin call, one strategy is to borrow much less than the maximum borrowed amount permitted. That way, when the markets become volatile, there will be some buffer before the margin requirements come knocking, which will help avoid selling stocks low.

Final note, as you can see with the examples above, investing with leverage amplifies both winners and losers. Do you own due diligence before using leverage to invest.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 9 comments… add one }
  • Dividend Growth Investor July 29, 2008, 11:21 am

    Another problem when using margin is that the interest rate might not be fixed, but floating. So if you take on some margin when investing in stocks make sure that interest rates are not increasing.
    That’s why if you want to use borrowed money in order to amplify your returns, do what FT does- take a mortgage on a property and then investing it in dividend paying stocks in order to get the cashflow to pay off the loan.

  • Super Saver July 29, 2008, 5:05 pm

    Of course, the best way to avoid margin calls is to not buy a stock that goes down. Unfortunately, I haven’t mastered this yet, so I avoid using margin ;-)

  • Accelerated Mortgage Program July 29, 2008, 6:59 pm

    interesting… thanks for the facts. im glad my dad works on a lot of stock/mortgage plans so he can help me to swallow all of this.
    -Jake

  • Don Yaschuk July 29, 2008, 8:49 pm

    Can this be used like a credit line? If so how do i pay back the loan and/or reduce my borrowing costs? Sure I put cash back into the account but how do I apply it to the loan? Thanks.

  • Pinyo July 31, 2008, 3:00 pm

    Since I use my brokerage account as a banking account, I used to have a bad habit of using my margin account as my check overdraft protection account. Well, it was a bit expensive and I am now working on NOT tapping into my margin account.

    I know you said margin account is another word for leverage, but I think using margin account to invest is more of a “sure bet” to lose your money.

  • Cannon_fodder August 5, 2008, 3:22 pm

    Thanks for this, FT. I’ve heard that there is an initial margin requirement and a maintenance margin requirement. I infer that you have to meet certain criteria to use margin when you first purchase a stock, but the maintenance margin is checked periodically (perhaps just shortly before the end of trading every day). If you are offside with margin then the brokerage will liquidate positions in order to get you back onside.

    Do you know if it is typical for an online brokerage firm to allow you to configure the system so that an alert (e.g. via email) is sent to you if you are getting close to a margin call?

  • FT FrugalTrader April 1, 2009, 1:43 pm

    cf, I’m a half year late replying to this one. :) The answer is that it depends on the brokerage. I know that IB will liquidate without warning, but others like Questrade will phone/email you.

  • Peter April 3, 2009, 12:17 am

    I guess that the interest you pay on the negative cash balance in your account is tax deductible as well since you’re “borrowing to invest” and all. That seems pretty clear.

    My question is this: If your broker issues a margin call on your account and you borrow money – say, from a line of credit – to cover the margin call, is the interest on the line of credit tax deductible as well? Can I claim the line of credit interest as an investment expense?

  • Chux03 April 7, 2009, 12:55 pm

    The best thing about a margin account for me is the fact that when you sell a stock, the money is credited to your account immediately, unlike a cash account, which takes 3 days. I’ve had such an account since starting to be more active in trading but have only used it a couple of times to (for instance) double my position in Yamana when it was $8 (like now) but I don’t think I’ve ever used more than $3k (10%) on a $30k valued account, though the margin is MUCH LESS than that with my IB account. Even if you don’t use the margin to buy stocks, there’s many aspects of a margin account that are very valuable to the stock investor who does some frequent trading but isn’t really a day trader either. Knowing both types of accounts would have me recommending upgrading to a margin account if for no other reason than what I’ve mentioned here….
    Good luck!!

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