Margin Investing Basics

In the same way that a bank will lend you money if you have equity in your house, your brokerage firm can lend you money against the value of certain stocks, bonds and mutual funds in your account. That borrowed money is called a margin loan, and can be used to purchase additional securities or for any other purpose.,as long as you have enough equity in your margin account to satisfy your borrowings.

Each brokerage can define, within certain guidelines, which stocks, bonds and mutual funds are marginable. The main thing to know is the higher quality the collateral, the more you can borrow against it.  Penny stocks normally have no marginable value, blue chip stocks which have listed options normally have the highest marginable value.

Follow this link to review the marginable rates on common securities. For example, you can borrow up to 70% of the value of a blue chip stock listed on the TSX which is on the IIROC approved list (which usually means one that has listed options on the MX). Most mutual funds have a 50% marginable value, whereas money market funds have a 95% marginable value.

If you are wondering what your margin position is, you will see a line item listed on your brokerage account statement or online profile that shows your available margin. This is the amount of cash you can take out of your account or use to purchase additional securities. If the margin amount is negative, you are under margined and will receive a “margin call”. Another aspect to keep in mind is margin is commonly treated as a global value between all types and currencies in your account. Meaning, your Canadian dollar margin balance and your US dollar margin balance will be netted for global margining purposes. So even though you may be under margined in one side of your account, you might not receive a margin call until your total account is under margined.

How does margin work?

Generally speaking, brokerage customers who sign a margin agreement can borrow up to 50% of the purchase price of marginable investments (the exact amount varies depending on the investment). Said another way, investors can use margin to purchase potentially double the amount of marginable stocks than they could using cash.

Few investors borrow to that extreme—the more you borrow, the more risk you take on—but using the 50% figure as an example makes it easier to see how margin works.

For instance, if you have $5,000 cash in a margin-approved brokerage account, you could buy up to $10,000 worth of marginable stock—you would pay 50% of the purchase price and your brokerage firm would front the other 50%. Another way of saying this is that you have $10,000 in buying power.

Similarly, you can often borrow against the marginable stocks, bonds and mutual funds already in your account. For example, if you have $5,000 worth of marginable stocks in your account, you can purchase another $5,000—the stock you already own provides the collateral for the first $2,500, and the newly purchased marginable stock provides the collateral for the second $2,500. You now have $10,000 worth of stock in your account at a 50% loan value, with no additional cash outlay.

Because margin uses the value of your marginable securities as collateral, the amount you can borrow fluctuates day to day along with the value of the marginable securities in your portfolio. If your portfolio goes up, your buying power increases. If your portfolio falls in value, your buying power decreases.

Margin interest

As with any loan, when you buy securities on margin you have to pay back the money you borrow plus interest, which varies by brokerage firm and the amount of the loan.

Margin interest rates are typically lower than credit cards and unsecured personal loans. And there’s no set repayment schedule with a margin loan—monthly interest charges accrue to your account, and you can repay the principal at your convenience. Also, margin interest may be tax deductible if you use the margin to purchase taxable investments.

The benefits of margin

Margin can magnify your profits as well as your losses. Here’s a hypothetical example that demonstrates the upside; for simplicity, we’ll ignore trading fees and taxes.

Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year passes, and that stock rises to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.

What happens when you add margin into the mix? This time you use your buying power of $10,000 to buy 200 shares of that $50 stock—you use your $5,000 in cash and borrow the other $5,000 on margin from your brokerage firm.

A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000 plus $400 interest which leaves you with $8,600. Of that, $3,600 is profit.

So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 for a gain of 72%.

The risks of margin

Margin can be profitable when your stocks are going up. However, the magnifying effect works the other way as well.

Jumping back into our example, what if you use your $5,000 cash to buy 100 shares of a $50 stock, and it goes down to $30 a year later? Your shares are now worth $3,000, and you’ve lost $2,000.

But what if you had borrowed an additional $5,000 on margin and purchased 200 shares of that $50 stock for $10,000? A year later when it hit $30, your shares would be worth $6,000.

However, if you sell your shares for $6,000, you still have to pay back the $5,000 loan along with $400 interest, which leaves you with only $600 of your original $5,000—a total loss of $4,400. As you can see, when taken to the limit, trading on margin makes it possible to lose your initial investment and still owe the money you borrowed plus interest.

Margin call

Remember, all the marginable investments in your portfolio provide the collateral for your margin loan. Remember, too, that while the value of that collateral fluctuates according to the market, the amount you borrowed stays the same. If your stocks decline to the point where they no longer meet the minimum equity requirements for your margin loan—usually 30% to 35% depending on the brokerage firm—you will receive a margin call (also known as a maintenance call). Your brokerage firm will ask that you immediately deposit more cash or marginable securities into your account to meet the minimum equity requirement.

An example: Assume you own $5,000 in stock and buy an additional $5,000 on margin, resulting in 50% equity ($10,000 in stock less $5,000 margin debt). If your stock falls to $6,000, your equity would drop to $1,000 ($6,000 in stock less $5,000 margin debt).

If your brokerage firm’s maintenance requirement is 30% (30% of $6,000 = $1,800) you would receive a margin call for $800 in cash or marginable securities to make up the difference between your equity of $1,000 and the required equity of $1,800.

Triggering a margin call