Margin Call: Buying on Credit Leaves Little “Margin” for Error

When searching for ways to enhance your investment returns, you may have come across the idea of using margin loans.  Before proceeding, be sure you understand the implications of what margin loans represent, and how to use them wisely.  You’ll want to avoid the dreaded margin call if at all possible. This post dives into margin lending by discussing how it works, its primary uses, advantages, and disadvantages, margin calls, as well as other related concepts.  The primary goal comes from understanding the risks posed by margin lending, why to consider buying on margin and what this option can do to your financial situation. Use margin wisely to lever your returns: kudos to you on finding extra return for measured risk.  Use margin blindly without thought given to consequence: poor financial outcomes resulting in potentially dire losses compounded by margin calls.

What is Margin?

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A margin account permits investors to borrow funds from their brokerage firm to purchase marginable securities on credit and to borrow against marginable securities already in the account.  The terms of a margin loan require the qualifying securities or cash held in the account be used as collateral to secure the margin loan. The brokerage levies interest on the borrowed funds for the time the loan remains outstanding.  Both the amount of money a brokerage loans to an investor and the terms of the loan agreement are subject to change. The Board of Governors of the Federal Reserve System, (the Fed), the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority Inc. (FINRA), and the clearing firm (brokerage firm) set and oversee margin lending rules.

How Do I Open a Margin Account?

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Investors interested in opening a margin account must make a deposit or cash or eligible securities totaling at least $2,000 in equity according to the NYSE.  This serves as collateral for the loan. Prior to opening, you must apply with your retail brokerage and demonstrate your understanding of how margin loans work. You must also acknowledge the associated risks with margin investing. Brokers like Webull charge margin rates between 3.99% and 6.99% [as of April 2020], depending on your amount borrowed. My prior education, experience and credentials in the finance field contributed toward receiving approval for the margin account application. After receiving approval, you may fund your account with cash or eligible securities to begin trading, subject to certain requirements. Webull asked me to complete an application stating my experience and familiarity with margin before proceeding with being granted a line of credit. From this point, Regulation T, promulgated by the Federal Reserve Board, allows you to double (or in some cases, quadruple) the amount invested in qualified securities.  This occurs so long as you maintain the minimum value necessary and conduct all trades within your margin account. This requirement, called the margin requirement, is the percentage of equity which must be deposited or maintained to purchase marginable securities or hold a position. In the case of margin investing, marginable securities are those securities eligible to be purchased on margin or used as collateral for a margin account. Brokerages will differ with securities allowed for margin accounts and not all will allow shorting stocks like Webull. Webull allows qualified securities to have leverage of up to 4x the asset’s value on day-trading and 2x on overnight trades. If you have interest opening a margin account, consider contacting a brokerage firm like Webull with competitive interest rates and a platform you understand how to use. Personally, I use Webull for my investing needs outside of Betterment, my 401(k) or IRA. This free stock trading app makes a great broker for margin trading. It even offers free stocks for signing up.  

Opening a Margin Account Example

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If you purchase $10,000 worth of marginable securities, you can choose to make the purchase with $5,000 of your own money and $5,000 of the brokerage firm’s margin loan. Investors who buy on margin pay interest on the loan portion of their purchase ($5,000 in this case), but normally do not repay the loan itself until selling the stock. However, depositing an equivalent amount of cash into the account can also satisfy loan repayment requirements (inclusive of associated interest, commissions and fees). After repaying the margin loan, any profit or loss belongs to the individual investor, less money used to pay interest accrued from the margin loan. Because the value of the marginable securities in your account serves as collateral for the loan, margin accounts require your equity amount meet or exceed certain minimum levels. If your collateral value should drop too low, your brokerage will ask you to increase the value of your account by trading assets held in your portfolio. Examples to satisfy this demand include selling securities, buying to cover open short positions, or closing options positions. As an alternative, you could deposit marginable securities or cash into the account to satisfy the equity requirements (equity = marginable stock – margin loans).

Which Securities Can You Buy On Margin?

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As a margin investor, you have a wide availability of marginable securities to trade in your account. These assets can serve as collateral against positions held in the account. Examples of eligible marginal securities include:

• Most securities listed on the New York Stock Exchange (NYSE)
• Majority of NASDAQ/AMEX (American Stock Exchange) securities
• Most mutual funds, after you have owned them for 30+ days
• Over-the-counter stocks approved by the Federal Reserve Board
• Certain corporate, municipal, and government bonds
• Stock futures

On the contrary, the following securities cannot qualify for a margin account:

• Coverdell Accounts
• Minor Individual Retirement Accounts (IRAs)
• Uniform Gifts to Minors Act (UGMA)
• Uniform Transfers to Minors Act (UTMA)

Regarding IRA accounts, these cannot borrow funds, be used to pay a debit balance, nor used to short stock or sell uncovered (naked) positions.

How Does Margin Lending Work?

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When you buy securities on margin, you only pay for a portion of the total cost. The brokerage firm extends credit to you for a portion of the balance, on which you pay or accrue interest charges monthly on the amount borrowed. The value of your marginable securities may fluctuate, but the amount owed to your brokerage firm should remain relatively constant, varying only with the interest charges made on your account. Because learning new ideas works best when seen through an example, let’s review an example of how leverage under Regulation T’s 50% requirement works in a margin account.

Margin Lending Example – Gain and Loss Scenarios

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Capital Gains

Imagine you open a margin account with a $10,000 cash deposit and a $10,000 margin loan. You choose to purchase 1,000 shares of a company’s stock for $20 per share, coming to a total position value of $20,000. If the stock price rises to $25 and you decide to sell, the proceeds amount to $25,000. You repay the $10,000 borrowed on margin and put $15,000 directly into your pocket, less any applicable interest, commissions and fees. This comes to a $5,000 profit, a 50% profit on your original investment. If you had used your own money and purchased $10,000 worth of stock in this scenario, you would have made a 25% return- a $2,500 gain on a $10,000 investment.

Capital Losses

On the contrary, let’s imagine a less rosy scenario. You purchase that same stock of 1,000 shares for $20 but the price proceeds to drop to $15 per share, representing a 25% decline in value. At this point, you choose to cut your losses short and sell. Your proceeds amount to $15,000 and you repay your brokerage firm $10,000 for the margin loan and put $5,000 in your pocket (less applicable interest, commissions and fees). This amounts to a net loss of $5,000, or a 50% loss on your original investment. If you had used your own money to make this purchase of $10,000 worth of stock, you would have experienced a 25% loss, or $2,500 on a $10,000 investment.

Margin Lending is a Double-Edged Sword

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As you can see from the examples above, buying on margin can potentially double your return on investments, or double your losses, depending on the stock price. If you can identify an actionable strategy on how to start investing money in a margin account wisely, you may have found a quicker way to financial independence. Likewise, if you find through poor decision-making your account returns to suffer and result in larger losses than through traditional, unlevered investing, you may opt to avoid margin investing. For a more comprehensive view of possible price fluctuations of a stock originally purchased at $20 per share and how they affect the status of a margin account, see the chart below*.  

What is a Margin Call?

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A margin call occurs as a demand upon an investor’s account to deposit money or securities with the brokerage firm when the value of the securities purchased on margin falls below the allowable level. When an investor’s account balance falls below one of a few required levels, the brokerage’s margin department, which computes the balances investors must have to avoid maintenance and margin calls, will contact you regarding the action(s) you must take. Margin accounts have three primary types of margin calls you can expect to receive if things go south:

1. Regulation T call. The brokerage issues this call when the initial equity provided for the purchase of a marginable security falls below the amount required by the Federal Reserve (50%).
2. Maintenance call. Occurs when the market value of your margined securities + cash balance held in your margin account – the debit balance of your account, drops below maintenance requirements.
3. Minimum equity call. A brokerage issues a minimum equity call when a trade reduces an investor’s account equity to less than $2,000 or if the investor’s account falls below one of the initial requirements listed in your margin account agreement.

When your brokerage issues a margin call, the investor must promptly bring the account to the required maintenance level. As a strong note of caution, should you choose not to take action to meet the margin call, your brokerage may sell stocks with or without prior notice to increase your equity percentage to satisfy the margin call requirement. Be sure to check your margin account agreement for more details, but most likely, any loss suffered by the margin investor when selling securities to meet a margin call will be the responsibility of the investor. I can’t say enough how any time a trade on your account can be made automatically without your express permission can pose extreme risks. This will be the case even if this comes standard with the account agreement. This requirement makes margin investing inappropriate for every investor. An investment strategy which includes trading on margin exposes the investor to:

• additional costs
• increased risks
• potential losses in excess of the amount deposited in the margin account

If you chose a self-directed investment account, you must carefully review your investment objectives, financial resources, and risk tolerance to accept the price fluctuations inherent to the stock market and the financial resources necessary to meet margin calls and absorb losses.

Margin Call Video Explanation

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In the below video clip from the movie “Margin Call” you can see an example of how selling assets in times of need would work. When the margin call comes, it happens fast and without concern for how you’d like to handle the situation, giving you little time to react. As a warning, the language gets a bit sharp at points, so please be aware and I advise viewer discretion.

Minimum Maintenance Requirements – Know the Margin Rules

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The Federal Reserve Board and many self-regulatory organizations (SROs), such as the New York Stock Exchange (NYSE) and FINRA, have rules governing margin trading. Most brokerages set their minimum maintenance requirement above the minimum level allowed by FINRA (25%). Also, special rules apply to trading penny stocks on margin. However, some brokerages also require certain securities to carry higher requirements given their inherent risks. Additionally, brokerages can establish their own maintenance requirements so long as they meet or exceed those of the Federal Reserve Board and SEO rules. The general margin maintenance requirements set by regulatory authorities are as follows:

• Minimum Margin – Before You Trade. Before trading on margin, FINRA, for example, requires an investor to deposit a minimum $2,000 or 100 percent of the purchase price of a marginable security, whichever is less.
• Initial Margin – Amount You Can Borrow. Regulation T from the Federal Reserve Board allows margin investors to borrow up to 50 percent of the purchase price of marginable securities. This is known as the “initial margin” and some firms require you to deposit more than 50 percent of the purchase price.  Also, not all securities qualify for margin trading.
• Maintenance Margin – Amount You Need After the Trade. After buying stock (or an asset) on margin, FINRA requires investors to keep a minimum level of equity in the margin account.  This equity = value of securities – margin loan.  Rules require an investor to have at least 25 percent of the total market value of the securities in the margin account at all times.  This 25 percent is called the “maintenance requirement.” Often, many brokerages enforce higher maintenance requirements, typically 30-40 percent, but also higher depending on the types of securities purchased.

As an example of how maintenance requirements work, let’s assume you purchase $10,000 worth of securities by borrowing $5,000 from your brokerage and paying $5,000 with cash or securities. If the market value drops to $7,500 of the position, the equity in your account falls to $2,500 ($7,500 securities value – $5,000 margin loan). If your brokerage uses a 25 percent maintenance requirement, you must have $1,875 in your account ($7,500 * 25 percent). In this case, you have enough equity because the $2,500 in equity remaining exceeds the $1,875 maintenance requirement. However, if your brokerage enforced a 40 percent maintenance requirement, you would not have sufficient equity in the account. The brokerage would require you to hold $3,000 in equity, thereby issuing a margin call for $500 ($3,000 maintenance requirement – $500 account equity).

Primary Uses of Margin Accounts

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People often choose to open a margin account and borrow against eligible securities for a variety of reasons. If the investor has a strong inclination an asset’s value will rise and needs additional capital to augment the potential returns of their conviction, margin loans can be a valuable tool. On the other hand, certitude in one’s convictions can turn to a strong bias and result in deleterious losses. Below are the primary uses for margin borrowing:

• To increase buying power and capitalize on potential market opportunities by leveraging an investment
• To purchase additional marginable securities
• To consolidate high-interest loans
• To use as an alternative to traditional borrowing sources
• To take advantage of a short-term cash-flow solution
• To use as overdraft protection

You will notice not all of the above relate to adding extra exposure to the stock market or investments. In some cases, you may have strong conviction in your investment positions and desire to avoid liquidation. As a result, you may find yourself in need of cash flow to meet everyday living needs without liquidating your investments. If you hold assets in a margin account, you may borrow against the marginable securities to resolve short-term cash flow problems or as a means to consolidate high-interest debt. Having the added ability to borrow against your assets can provide better financial planning flexibility and allow you to meet your recurring obligations without incurring tax consequence stemming from the sale of investments.

Primary Advantages of Margin Accounts

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When evaluating whether margin investing would benefit your financial position, you’ll want to know the primary benefits associated with margin accounts. Some of the largest benefits include:

• An increase in passive income from cash dividends
• Potential capital appreciation leveraging
• Competitive interest rates
• Alternative source of financing to meet business or personal needs without additional paperwork, application fees, or time (similar to an open line of credit)
• Margin interest may count as a tax deduction in certain situations

Just as leverage adds more power when used to perform a task (e.g., buying a home, car, or other large purchase), leverage in a margin account also increases your financial power with a relatively small amount of cash. However, just as you may realize higher profitability if the price of the assets you buy on margin goes up, you risk increased losses should the asset value decline. If the margin value of your account drops below your brokerage’s maintenance requirements, you will receive a maintenance call and need to bring your account equity to the required balance immediately. Margin can leverage your capital appreciation potential, but also the amount of income you can stand to make. For example, if you use margin loans to purchase dividend-paying stocks, bonds, or other income-producing assets, the stream of payments which come from those assets will belong to you. Essentially, you’ll have borrowed money to buy more income-producing assets much how you borrow money to buy rental property. In both scenarios, risks abound and require careful monitoring, deliberation, and risk assessment. If you can find a smart balance, margin accounts can unlock higher returns.

Primary Disadvantages of Margin Accounts

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Just as margin accounts can bring newfound wealth, they can just as easily result in dramatic erosion of your net worth if handled poorly. As a margin account holder, you face:

• Risk of increased loss – margin investors may lose more than the amount deposited in their account
• Potential maintenance call or liquidation of marginable securities without notice
• Because price fluctuations can lead to margin calls with little notice, margin accounts require much more attention and are not ideal for passive investing in index funds for the long-term path of learning how to build wealth

My Experience with Margin Lending

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Before I share how I have used margin in the past, I want to share my view on investing risk.

How I Think About Risk

Investing consists of dealing with one thing: the future.  Because none of us have perfect predictive powers, risk is inescapable. That being said, risk is something which can be estimated and managed to your advantage. If you can manage to find investments using the best financial apps for young adults you feel have a higher probability to go up than down, then you’ve moved in the right direction, assuming you aim to increase your money. Leverage is simply a tool to enhance this certainty with a higher return.  Margin leverages returns and does not replace the necessary due diligence required in effective investing. I would suggest someone use margin loans when they’ve done a considerable amount of stock research on the best apps and software to assess price probabilities and determined the likelihoods behind price outcomes. This is especially true when it is more likely than not the price will increase. The same applies if an investor chooses to short a stock with a margin loan: be more certain than not the price will decline. Determining the market’s movements is fraught with risk and is best assessed through probabilities. In moments of market volatility, difficulty arises to gauge where a stock (or the market in general) may head.  Economies and markets move up and down. Whichever direction they’re moving at the moment, investors tend to think they’ll head that way forever. Thinking like this can be dangerous and detrimental to returns.  Margin loans are a means to an end. They are a tool to augment your returns when you have relative certainty of how your investment will perform. I would not recommend using this loans on a recurring basis unless you fully understand the associated risks. Using margin loans should be accompanied by someone with a strong stomach and strong conviction.

My Preparation and Success

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After reading numerous earnings call transcripts, press releases, and news articles, I developed a strong feeling one of my stock holdings stood to move upward in the near future. By seeing the stock’s price movement as a possibility of outcomes, I saw the odds favored an increase in price as opposed to a decrease due to a number of factors. In this case, the primary one being strong earnings performance from banking competitors who had outperformed the market. As competitors reported earnings and exceeded the market’s expectations, their stocks elevated. You would have expected an industry tailwind to feed through to my stock’s price but it decidedly remained still despite the surrounding market activity. I saw this as an opportunity to add more value to my existing position and take advantage of borrowed money to leverage my returns. I used a margin loan from my brokerage, Interactive Brokers, to grow my position by an additional 25%. I knew the risks of using the borrowed funds but felt very strongly in my conviction the company’s earnings would do well. As it turned out, the bank did benefit from a strong market and beat earnings expectations. The stock rallied more than 40% in the ensuing month and I sold my leveraged position for a nice gain. On a percentage basis, I made a 50% return. (40% + 10% (40%*25%)). While I would hesitate to use much leverage in the future absent my strong conviction, the availability of the funds provided for a nice anniversary present for my wife and I. These proceeds financed our one-year anniversary trip to Europe. I knew the risks going in and the possible rewards I stood to make if I made an accurate prediction. The trade could just have easily gone against me and cost me some much-needed funds. Fortunate for me, I wasn’t on the losing end of the trade.

Know the Risks of Margin

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As an investor, should you choose to use borrowed funds in a margin account for investments, this will multiply the inherent risk of investing. If you invest with cash, you will have disappointment when your asset loses value.  However, if you invest with a margin loan only and the asset value declines, you could end up owing more than the worth of the asset itself. In other words, you could end up “underwater” on your margin loan for the investment, owing more than you could get back by selling the investment. This can damage your personal budget if you struggle to repay this loan, and can even lower your net worth. When using margin loans for investments, you’ll have costs of interest and the burden of making monthly payments on top of the increased risks. Because of this, your expected return on your investment must rise commensurately in order to account for this higher capital cost. Simply put, your annual returns or growth on an investment will need to exceed your interest rate, or you’ll lose money. Therefore, to justify a 10% interest rate, you’d need at least a 10% return on an investment.  Otherwise, you’ve made no money for your added risk. Also, don’t forget about the long-term effects inflation on your returns. But not every borrower will be offered low margin rates which could make this work, nor are there any guarantees that your investment’s performance will match your expectations. As you seek higher returns you encounter higher risk and therefore more uncertainty. Overall, taking on a margin loan will get you into debt and add a new financial obligation to your monthly budget.  When possible, it can be wise to limit borrowing and only use credit when needed. And as a concluding thought, investing is not a need, but rather a means to an end. Often, investing can wait until you find yourself in a position to invest with cash rather than credit. If you subscribe to the long-term passive investing philosophy, which aligns with my recommendation as the best investments for young adults, holding leverage for extended periods of time can serve as a detriment to your net worth if not managed wisely. Ultimately, when you choose to invest with borrowed funds, you find yourself with little “margin” for error. Readers: Have you used margin lending to lever your returns? What lessons did you learn? Please share your thoughts below. Also, please consider subscribing to the e-mail newsletter below and sharing this across social media because I can’t reach a larger audience without your help.