What is Margin?

Buying on margin is like riding a motorcycle...

Sometimes you want to get to your destination a bit faster. By riding a motorcycle you can dodge through traffic and overtake slower vehicles. But it’s also riskier than driving a car. You need to weigh the pros and cons, and understand the risks you’re taking. Margin is similar. What you do with the money you borrow is your decision, but ultimately, you’re on the hook for that amount plus any interest. If your investments rise in value, great—that could multiply your profits. But if your investments fall in value, margin could multiply your losses.

Buying on margin involves using a combination of your cash or other assets and borrowed funds from your broker to buy securities like stocks and bonds. For example, you may pay 60% of the cost, and your broker may loan you the other 40% to make a purchase. You pay interest on the amount you borrowed. When you sell the securities, you pay back the loan. If the assets have gone up in value, you make a profit. If not, you may lose money on the investment, and you still have to pay back what you borrowed.

The first step is to find a brokerage that offers accounts that allow you to buy on margin. When you apply for a margin account, the broker may consider your income, net worth, credit history, and other factors when deciding whether to issue approval. It is wise to read the margin account contract carefully to make sure you understand all the terms.

Once the broker has approved your margin account, you’ll need to deposit funds. The Federal Reserve Board, which governs the U.S. central banking system, requires a minimum 50% initial margin (meaning you can fund half of the purchase price and borrow half), but brokerages can choose to require more.

The Financial Industry Regulatory Authority (FINRA), a government-authorized regulator of brokerage firms, mandates that investors deposit at least $2,000 before trading on margin, but your broker can require a higher amount. You also need enough cash to cover your share of the purchase.

If you buy on margin, FINRA also requires you to keep at least 25% equity in your account with the brokerage, known as the maintenance margin. You can calculate your equity by taking the value of securities you own and subtracting the amount you owe to the broker. Your brokerage may require a higher maintenance margin than FINRA does. If you fall below this floor, you can’t continue buying on margin. You may also have to repay the amount borrowed quickly if the value of the security purchased on margin, or of your entire portfolio of assets continues to drop. This is known as a margin call.

A margin call happens when you fall below the required maintenance margin. In other words, you owe the broker more than brokerage and FINRA rules allow relative to the value of your stocks or bonds. A margin call is when the broker contacts you and asks you to deposit funds or securities to bring the account up to the margin maintenance minimum. If you can’t deposit the assets quickly, the broker may sell some of your securities. Note that your broker doesn’t necessarily have to tell you before he starts selling your assets; your margin agreement (the contract for the account) spells out his obligations.

People choose to buy on margin to own more of a security than they could otherwise. One reason to do this is to buy stock you believe is an excellent long-term investment but typically trades at a higher price than you can afford. You could borrow to cover the cost until you’re able to pay the money back, assuming you believe your gains will outweigh interest and other costs of buying on margin.

Another reason is that you might believe the price of a security will jump in the near future, and you want to buy more of it in order to sell it quickly at a profit. However, buying on margin, like investing in general, does not mean a guaranteed gain and carries significant risks.

Buying on margin can be a good idea for some investors, but not others. Your personal tolerance for risk, your ability to withstand losses, and your level of understanding about how margin works all play a role in whether this strategy is right for you.

When buying on margin goes well, you might make a profit while investing less money. But risks can be significant. If your securities lose value, you not only lose money on the investment but still have to pay back the money borrowed with interest. You also run the risk of a margin call, which requires you to pay funds back quickly or have your securities sold off to cover the debt. Even if your investments don’t drop in value, you still have to pay interest for borrowing funds, which you wouldn’t have to do if you only invested money you had.

Short selling stocks and margin trading are both investment strategies that involve some borrowing, but they’re not the same. While margin trading involves using borrowed money to buy securities such as stocks, short selling involves selling borrowed stocks or commodities (raw materials or crops, such as silver or corn).

Here’s how short selling works: You borrow shares from a broker, sell them on the market, and then return an equal number of shares to the broker at some point in the future. Investors often short sell when they expect a stock to fall hard in a short time. The hope is to sell the borrowed stock at a high price, then buy the same number of shares later at a much lower cost to return to the broker.

On October 24, 1929, often called Black Thursday, the stock market started falling after a period of rapid growth. More losses followed the next Monday (Black Monday) and Tuesday (Black Tuesday) and continued until 1932, when the Dow Jones Industrial Average fell to a rock bottom of 41.2 points (down from a peak 381.17 in Sept. 1929).

Many factors led up to the crash, but what got many ordinary Americans into trouble as the Great Depression began was margin. The stock market had been so profitable that many people with limited funds wanted in on the action and bought on margin. At the time, federal rules allowed them to borrow up to 90% of the stock value. When the market crashed, many investors couldn’t afford the margin calls and lost everything, leaving them with no safety net to weather the effects of the collapse. Many large investors were caught up in margin as well and ended up too overextended to cover their margin calls.

In regular conversation, margin usually means a difference between the two items. The term comes up a lot in finance. Here are two of the most common uses:

Corporate Accounting In corporate accounting, margin usually refers to gross profit margin, which is the difference between sales and the cost of goods sold (the direct expenses of making the company’s products, including materials and labor). Sometimes called the gross margin ratio, this is often shown as a percentage of sales. Margin can also refer to operating profit margin, which tells you a company’s return on sales.

Mortgage Lending In mortgage lending, margin is part of calculating adjustable mortgage rates. The lender starts with a base rate tied to an index, like the Treasury Index (an index based on U.S. Treasury bill auction rates), then adds a margin to come up with the actual interest rate it will charge. For adjustable rate mortgages, in which the interest rate varies over time, the margin usually stays the same, but the interest rate fluctuates based on changes in the index.

Additional Disclosure: Margin borrowing increases your level of market risk, as a result it has the potential to magnify both your gains and losses.

Regardless of the underlying value of the securities you purchased, you must repay your margin loan.

Your broker can change their maintenance margin requirements at any time without prior notice.

If the equity in your account falls below the minimum maintenance requirements (varies according to the security), you’ll have to deposit additional cash or acceptable collateral.

If you fail to meet your minimums, your broker may be forced to sell some or all of your securities, with or without your prior approval. For more information please see Robinhood Financial’s Margin Disclosure Statement, Margin Agreement and FINRA Investor Information.