What it means
In a margin account, the investor puts up part of the purchase price (the margin) and the broker lends the rest. The shares bought and any other securities in the account act as collateral.
Interest is charged on the borrowed amount for as long as the loan is outstanding. The attraction is leverage.
If an investor with $10,000 can buy $20,000 of shares, a 10% rise in the shares produces a 20% gain on the investor's own money. The same arithmetic works in reverse, so a 10% fall produces a 20% loss, and losses can be larger than the money originally put in.
Regulators and brokers set two key limits. The initial margin is the share of the purchase the investor must fund with their own money, which in the United States is commonly 50% under federal rules.
The maintenance margin is the minimum equity the account must hold afterwards; regulators set a floor and brokers often require more. When account equity falls below the maintenance level, the broker issues a margin call, which is a demand to deposit more cash or securities.
If the investor does not respond in time, the broker can sell holdings without asking, often at poor prices. This forced selling is why margin positions can unwind violently in falling markets.
Businesses meet margin trading in treasury and investment teams, and in the risk reports of banks and brokers. The practical rule is that margin is a loan, so the cost of interest, the risk of forced sales and the effect on the overall portfolio need to be judged together.
In practice
Real-world examples
Example 1
A private investor with $50,000 buys $100,000 of an index fund on margin, expecting a rally. The fund rises 8%, giving a gain of $8,000 on the investor's $50,000, a return of 16% before interest. The margin loan interest takes a slice of that gain.
Example 2
A small proprietary trading firm uses margin to hold larger positions in listed stocks than its capital alone would permit. Its risk manager sets an internal limit that keeps equity well above the broker's minimum. This avoids being forced to sell on a bad day.
Example 3
A founder who has sold part of her company is tempted to borrow against the proceeds in a margin account to buy more shares in a technology company. Her adviser points out that a sharp fall could trigger forced sales of the whole portfolio. She decides to cap borrowing at a small fraction of her holdings.
Think of it
Margin trading is like buying a house with a very small deposit and a massive mortgage. If the property market goes up, your percentage return on your actual cash is huge. But if the property value crashes below your loan amount, the bank demands immediate cash to cover the gap.
Formula
Calculation
Equity ratio = (Market value of securities - Loan) / Market value of securities
Suppose an investor buys $20,000 of shares using $10,000 of their own cash and a $10,000 margin loan. The shares fall 30% to 20,000 x 0.70 = $14,000. Equity is now 14,000 - 10,000 = $4,000, so the equity ratio = 4,000 / 14,000 = 28.6%. If the broker's maintenance requirement is 30%, the account needs equity of 14,000 x 0.30 = $4,200, so the investor faces a margin call for 4,200 - 4,000 = $200. The loss on the investor's own cash is 6,000 / 10,000 = 60%, from a 30% fall in the shares.Case study
Seen in the real world
Marlowe Capital Partners is an illustrative, fictional investment club with eight members and $400,000 in pooled savings. The treasurer proposed borrowing a further $400,000 on margin to buy a basket of mid-sized company shares, doubling the exposure. In a rising market, the club's return in the first quarter was 18% on its own money, against 9% without borrowing.
In the second quarter the market fell 20%. The basket was now worth $640,000 against a loan of $400,000, leaving equity of $240,000 and an equity ratio of 37.5%. A further fall would have triggered a margin call, and the club had no spare cash.
The members agreed to repay half the loan by selling shares at the lower price. The illustrative lesson is that the same borrowing that boosted the early gains left the club with little room to manoeuvre once prices fell.
Watch out
Common mistakes
- Believing that losses are limited to the money deposited, when margin losses can exceed the investor's own cash.
- Ignoring the interest on the margin loan, which reduces returns and is charged even when the investment loses money.
- Assuming there will be time to raise cash, when brokers can sell holdings immediately if the account falls below the required level.
Questions
People also ask
What is a margin call?
It is a broker's demand for additional cash or securities after the account's equity drops below the maintenance requirement.
Is margin trading the same as short selling?
No, margin trading is borrowing money to buy securities, while short selling is borrowing the securities themselves to sell, although both are usually done in a margin account.
Can the broker change the margin requirements?
Yes, brokers can raise requirements at short notice, especially for volatile or concentrated holdings, so the limit that applied yesterday may not apply tomorrow.