How Margin works
Let’s say you’re confident the price of a security or instrument will rise, and you’d like to increase your expected profits, but you don’t want to deposit extra funds in your trading account. You decide to buy extra shares on margin.
If you have $10,000 in a cash account you could buy 500 shares of a $20 stock. However, in a margin account, you could use your $10,000 to buy 1,000 shares of the $20 stock -- twice as much. In the U.S. the initial margin for stock purchases is 50%. This means you only have to pay $10,000 toward your $20,000 purchase. The broker loans you the remaining $10,000 to complete the buy.
The broker shows this loan as a debit balance when you look at your margin account statement. Like any loan, it only changes if you borrow more, pay it down, or if interest charges are added to it. In a margin account, the equity (net account value) is determined by subtracting the debit balance from the current market value.
Costs of Margin
For the service of providing margin, the broker charges you interest on the margin loan and also profits from extra commissions on your increased share purchases.
Margin allows you to “leverage” an investment -- to use borrowed money to increase profits above what a cash-only investment would return. But beware! Leverage is a double-edged sword. If the price of the leveraged security goes up, you’re rewarded. However, if you use too much leverage, and the margined security declines in price, losses can mount quickly.
Risk increases as leverage increases. Because of this, market regulators and brokers restrict how much leverage investors are granted.
As in the above example, let’s say you buy 1,000 shares of a stock in a margin account at $20, costing $20,000. The margin requirement is 50%, so you deposit $10,000, and borrow $10,000 from the broker. You expect the price of the stock to rise, but you’re wrong, and it falls to $5. What happens to your margined investment?
Well, you’d still owe the broker the $10,000 you borrowed initially. But now the market value of the 1,000 shares has declined to $5,000 (1,000 shares x $5). So market value is less than what’s owed the broker -- there is negative equity of $5,000 (an unsecured debit balance). The broker will issue a margin call, demanding you deposit more money.
While margin trading can magnify profits, it only takes one very bad leveraged investment to wipe out the profits from many successful margin trades.