Margin trading has been around for decades and there's a good reason for that.
Margin accounts offer flexibility to investors, who use the strategy to take advantage of market opportunities by borrowing money from their brokerage firms to buy stocks that they may otherwise not be able to afford.
The downside risks on margin accounts are abundant, however.
The biggest risk is that, no matter how the stock you purchased performs, you have to pay the money back. Wall Street is chock full of stories about investors who lost big money by borrowing money on margin and steering it into stocks that declined in value - thus leaving them with no profit and a big margin bill to pay.
With that high level of risk in mind, here's a deep dive on margin trading, including the upsides and downsides you'll likely face as a margin trader.
What Are Margin Accounts?
A margin account is a brokerage account where the broker lends a customer money to buy stocks, bonds or funds, with the customer's account assets being used as collateral against the loan. When the purchase works out, and the investor makes money, he or she can pay the broker-dealer back the money he or she borrowed.
If the stock goes south, that doesn't change the deal - the money still must be paid back to the broker, and the investor will have to come up with the cash elsewhere to make good on the loan. Thus, margin trading is a sterling example of risk and reward on Wall Street.
It's worth noting that margin accounts are not cash accounts.
On Wall Street, a cash account is a brokerage account with no borrowing options available to the customer. Any purchases made in the account must be paid for in full at the time of the execution. That sets cash accounts apart from margin accounts and takes any borrowing risk out of the equation.
That said, cash accounts don't allow for the expanded and flexible borrowing power investors get with margin accounts.
Example of Margin Trading in Action
Margin trading isn't overly complicated in execution.
For instance, you're a margin investor who purchases XYZ stock for $100 and the price of the stock soars to $150 per share.
Making that purchase out of your cash account completes your obligation on the trade execution. You paid $100 for the stock and your $50 profit is your return on investment, and you can sell at that price and then lock in that financial gain at a 50% profit.
In the same scenario, you paid $50 in cash for XYZ stock and borrowed $50 from your broker, on margin, to pay for the rest of the purchase. In that scenario, you're locked into a gain of 100%, as you only used $50 of your own money to buy the stock. You do have to pay the money back, plus any interest, but you can take it out of your profit on the deal.
But what if the share price of XYZ stock falls by $50, instead of rising by $50? In a margin account, you'll lose 100% of your investment, after paying back the broker, and you still owe interest on the margin loan.
If the price of a stock falls severely (usually when the overall market is also in decline), a broker has the right to issue a margin call: A demand that the investors provide either sufficient cash or securities to cover margin loans.
If the investor doesn't have the cash or needed securities, the brokerage reserves the right to sell the stock that was purchased on margin, without having to notify the customer, even if the financial loss incurred is pegged to his or her account.
Five Risks Associated With Margin Accounts
While the upside of margin accounts is promising, investors need to do their due diligence on margin accounts, and fully understand the risks attached to margin trading. Here's a risk "checklist."
1. Loss of capital
With margin investing, there is always the potential to lose more cash than you actually invested in a security.
2. Coverage demands for potential losses
Margin accounts are in a precarious place in declining markets, as skittish brokerage firms can demand that margin account holders push cash or securities into their accounts to cover potential investment losses, and do it in a very short period of time.
3. Forced to sell
Additionally, to cover potential account losses, margin customers may have to sell securities to cover investment losses incurred in their account - or, even worse, have their stocks sold for them by the broker without any say in the matter.
4. No choice
When a broker decides to sell securities in your account to cover losses, the broker will decide which stocks to sell, and you, again, have no say in the matter.
5. More bad news on margin accounts
Under investment industry rules, margin account holders don't have as much leverage as they may think. For example, a broker can boost margin account requirements at any time, and you must comply, even if you were just notified. Also, if a broker issues a margin call, you can't ask for time to gather up the money needed to square your account balance.
Tips on Using Margin Accounts
Getting educated and knowing the risks involved are the best moves to make to protect yourself when using margin trading accounts with your broker.
For a real-world breakdown, here are some tips and strategies you can deploy to maximize your margin trading experience, and protect yourself from downside risk:
1. Ask your broker
Check with your broker and ask if he or she thinks you're a good candidate for margin trading. Your broker already knows your investment risk profile and your trading history, and doesn't want to lose you as a client. Consequently, he or she will likely be candid with you and lay your chances of succeeding as a margin investor right on the line.
2. Review the contract's fine print
When you opt to use a margin account, your broker will issue a contract spelling out the terms of the agreement. Or, your broker will have included margin contract stipulations in your original broker/customer agreement.
Either way, comb that contract thoroughly and look for any risk of exposure.
You'll see plenty of legal boilerplate involving the main margin trading regulators, like the Federal Reserve and FINRA, so if you're at all confused, take the contract to a good contract lawyer and have it explained to you. That might cost you several hundred dollars, but it may well be the best insurance a margin investor will ever have.
3. Understand the rules
Your margin contract may stipulate certain obligations you'll have to clear before you start trading, like a minimum deposit (FINRA calls for a $2,000 minimum deposit, or at least an amount of cash equal to 100% of the security price, into margin accounts). Also, some brokers may demand that you deposit more than the 50% of a security's price you're allowed to borrow under margin trading rules.
Make sure you know your obligations going into a margin deal before signing on the bottom line.
4. Be realistic about margin calls
Margin calls can upset your brokerage account applecart in one fell swoop, and it happens more than you think.
Consequently, it's up to you to check with your broker and ask about specific conditions where money or securities will be demanded via margin call. Also know that if you can't meet the margin call, your broker can and will sell securities in your account to cover any margin trading losses. They don't even have to give you a heads-up before doing so.
5. Curb your risk exposure
It's a good idea to view margin trading as a short-term strategy, one where you use your margin account sparingly and only to try to reap short-term market gains. That reins you in from making more long-term, speculative trades that can really come back to haunt you.
Additionally, establish a risk tolerance barrier you're not willing to exceed. Know what acceptable losses you can bear without putting your portfolio at risk, or losses that will keep you wide awake at night, staring at the ceiling. Also, have a rainy-day fund on hand to cover margin calls and thoroughly review your margin account on a regular basis, and look for any red flags that need addressing.
Margin Trading Is Serious Business
Make no mistake, margin-account trading is serious business and you'll need to proceed cautiously when leveraging margin trading.
Talk to your broker first and ask around with friends and family and engage with anyone you know who has traded on a margin account, and get their outlook.
Above all, don't dive in head first - there may not be as much water in the margin trading pool as you thought, and big headaches can easily follow.