Trading on margin enables you to leverage securities you already own to purchase additional securities, sell securities short, or access a line of credit. While there are many benefits to establishing a margin account, it’s also critical to fully understand the risks before you get started. Before discussing the risks, let’s first examine the primary benefits of using margin.
- While margin loans can be useful and convenient, they are by no means risk free.
The opportunity to leverage assets
When you buy securities on margin, you are able to leverage the value of securities you already own to increase the size of your investment. This enables you to potentially magnify your returns, assuming the value of your investment rises.
Federal Reserve Board Regulation T allows investors to use margin to borrow up to 50% of the value of a securities purchase. Therefore, if you wanted to purchase $10,000 worth of a stock, you could invest $5,000 of your own assets and use a margin loan to buy an additional $5,000 worth of shares, for a total investment of $10,000.
The ability to profit from share price declines
Short selling is a sophisticated strategy whereby an investor seeks to profit from a declining share price. In order to sell a security short, you must first borrow shares of stock from a brokerage firm, which requires that you have an approved margin account.
After you borrow shares, you sell them and then buy them back at a later date, presumably at a lower price. The difference between the proceeds of the original sale minus the amount required to buy back the shares would be your profit.
Assume that, after doing your research, you concluded that ABC Company was unlikely to meet its revenue goals due to a successful new product launch from ABC’s foremost competitor. You then use your margin account to borrow 100 shares of ABC stock and sell it short at $50 a share for a total of $5,000 (minus commission charges).
Six months later, ABC’s stock price has declined 20% to $40. You buy 100 shares at $40, return the 100 shares of stock to your brokerage firm, and pocket the difference of $1,000 (minus commissions, margin loan interest, and any taxes). This is another example of how trading on margin can provide opportunities to leverage your assets for financial gain.
The ability to diversify a concentrated portfolio
If your portfolio is dominated by a large block of stock from one company, such as a current or former employer, you could be putting too many eggs in one basket. With a margin account, however, you may be able to use those shares as collateral for a margin loan. You can then use the loan proceeds to diversify your portfolio without having to sell your original shares of stock. This strategy can be particularly helpful if you have a large unrealized capital gain and want to keep it that way.
A convenient line of credit
Once your account has been approved for margin borrowing, you can take out a margin loan at any time, without any additional forms or applications. This ready access to cash may prove to be convenient in a number of scenarios, such as when you are unemployed, experience an unexpected medical bill, or need a quick way to access cash for any other reason. If your brokerage account includes checking, you can simply write a check.
Low interest rates
Like any loan, you will incur interest charges with a margin loan. However, because margin loan rates are pegged to the federal funds target rate, your interest rate may be lower than what you would pay for a credit card cash advance or a bank loan, especially on larger balances. Margin rates may also be competitive with rates on home equity loans, without all the paperwork and application fees.
So long as your debt doesn’t exceed your margin maintenance requirement, you can pay back your loan on your own schedule.
The interest that accrues in the account may offset taxable income. Consult your tax advisor for details regarding your particular situation.
The ability to participate in advanced options strategies
Being approved for both a margin account and options trading allows you to place advanced options orders, such as spreads, butterflies, and uncovered options on equities, ETFs, and indexes. You can access additional information about trading options within the Fidelity Learning Center.
To facilitate participation in an employee stock option plan
Some employers offer stock options to their employees. This enables you to exercise an option to buy shares of stock at a discount to its present value. To exercise these options, you must have enough cash to pay for the shares. Using a margin account, you can use the securities in your account as collateral for a loan to pay the cost of exercising your options. This enables you to avoid selling securities and incurring a taxable capital gain, or using up all of your available cash.
Where there’s potential reward, there’s potential risk
While margin loans can be useful and convenient, they are by no means risk free. Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.
Margin can magnify your losses just as dramatically as it can boost returns.
Risk of being unable to meet a margin call
Your brokerage firm will require you to maintain a specific percentage of equity in your account, depending upon the types of securities you own and whether you borrow money to buy additional shares or sell short.
Equity reflects your ownership interest and is calculated by subtracting your margin loan balance from the total value of your account. For example, if the value of the securities in your account was $15,000 and your margin loan balance was $10,000, your equity would be approximately $5,000 or 33%. For stock positions, the minimum equity maintenance requirement is typically a 30% base but could be higher due to a number of security and/or account factors.
If the value of the securities you are using as collateral for your margin loan falls below the minimum equity maintenance requirement, your account may incur a margin call. This means you will need to add cash or securities to your account to increase your equity. If you do not act promptly, your brokerage firm may sell securities you own—without notifying you—in order to increase the equity in your account.
Ways to manage margin account risk
- Consider leaving a cash cushion in your account to help reduce the likelihood of a margin call
- Prepare for volatility; position your portfolio to withstand significant fluctuations in the overall value of your collateral without falling below your minimum equity requirement
- Invest in assets with significant return potential; the securities you buy on margin should, at a minimum, have the potential to earn more than the cost of interest on the loan
- Set a personal trigger point; keep additional financial resources in place to contribute to your margin account when your balance approaches the margin maintenance requirement
- Pay interest regularly; interest charges are posted to your account monthly, so it makes sense to pay them down before they build to unmanageable levels