Margin trading, sometimes known as “buying on margin,” means borrowing money from your brokerage company and utilizing that money to buy stocks. Simply put, you’re taking out a loan, purchasing stocks with the borrowed funds, then repaying the loan — usually with interest — at a later date.

Buying on margin has some serious appeal when compared to buying with cash, but it’s important to understand that with higher returns comes more risk. Margin trading is a kind of leverage that investors employ to magnify their returns. However, if the investment does not proceed as planned, losses may be magnified.

How Margin Trading Works?

A margin loan, like a secured loan, requires the investor to supply collateral, which functions as a security deposit. The loan is secured by the value of the assets held in an investor’s account, which includes cash and any investments such as stocks and mutual funds. Most brokers demand investors to have at least $2,000 in their account in order to borrow on margin.

The credit limit – the amount an investor may borrow — is allowed by the price of the asset being purchased and the value of the collateral. A broker would typically permit an investor to borrow up to 50% of the purchase price of a stock, up to the amount in collateral in the account. Assume you wish to buy $5,000 worth of stock on margin and put half of that down. You must have enough cash in the account (referred to as “initial margin”) to cover $2,500 of the tab in order to borrow the remaining $2,500 on margin.

The borrower is charged interest, just like any other loan. The brokerage determines the loan’s interest rate by creating a base rate and either adding or deducting a percentage dependent on the loan’s size. The lower the margin interest rate, the greater the margin loan. According to one large brokerage, an investor borrowing $10,000 to $24,999 in 2020 would pay an 8.70 percent interest rate on the loan, but an investor borrowing $100,000 to $249,999 would pay an effective rate of 7.45 percent. Monthly interest is calculated and applied to the margin balance. When the asset is sold, the revenues are used to pay off the margin loan first.

What are Maintenance Requirements and Margin Calls

Margin loans, unlike mortgages, are always tied to an investor’s brokerage account’s constantly fluctuating level of cash and securities (the loan’s collateral). To comply with the terms of the margin loan, investors must have a certain amount of cash and securities in their accounts, referred to as the broker’s “maintenance level.”

If the value of those securities decreases and the collateral falls below the maintenance level (which may happen if any of the equities in the portfolio, including those purchased on margin, declines), the broker will issue a “margin call.”

An investor has from a few hours to a few days to raise the account value up to the minimum maintenance level at that moment. She may raise the amount of cash in the account by depositing additional cash or selling stocks (or cancelling option contracts).

If the margin call deadline is missed, the broker will pick which stocks or other assets to sell in order to bring the account back up to date.