What Is Margin Debt?
Margin debt represents the amount a brokerage customer borrows by engaging in trading on margin. It’s a method where investors opt to use a margin account instead of a cash account, thus borrowing part of their initial investment from brokers. The borrowed amount is termed as margin debt, while the portion funded by the investor is known as the margin or equity.
Using margin debt introduces both significant risks and potential rewards.
Key Takeaways
- Margin debt: Money borrowed from a broker via a margin account.
- Purpose: Can be used to purchase securities.
- Regulation T: Sets an initial margin at 50%, allowing for borrowing up to 50% of the account value.
- Typical margin requirement: Brokerages typically require maintenance of 25% equity to avoid margin calls.
- Leverage: Amplifies both potential gains and losses.
How Margin Debt Works
Imagine an investor named Sheila keen on buying 1,000 shares of Johnson & Johnson (JNJ) at $100 per share. Rather than paying the entire amount upfront, Sheila decides to use a margin account due to borrowing constraints set at 50% by Regulation T.
Sheila deposits $50,000 as initial margin and borrows the remaining $50,000, accumulating $100,000 in JNJ stock. Here, the 1,000 shares serve as collateral for the loan.
Note:
History shows that excessive margin trading was a significant contributor to the 1929 U.S. stock market crash. Back then, margin rules were laxer, often allowing investors to borrow 90% of the money to buy securities, requiring only a 10% cash deposit. We know today how detrimental that turned out to be.
Advantages and Disadvantages of Margin Debt
Buying on margin involves a mixture of risks and potential advantages, generally making it unsuitable for beginners or those who can’t afford potential losses.
Disadvantages:
Let’s explore the potential risks:
When Johnson & Johnson’s stock price drops to $60, Sheila’s margin debt remains at $50,000, but her equity plummets to $10,000 ($60,000 stock value - $50,000 margin debt). The Financial Industry Regulation Authority (FINRA) mandates a maintenance margin of 25%, requiring customers’ equity to stay above that threshold.
A violation of this mandate initiates a margin call. To meet the minimum requirement (25% of $60,000 or $15,000), Sheila must deposit another $5,000 or face her broker selling off stocks to meet the margin rules, without prior notification.
Various brokerages might enforce stricter rules, sometimes requiring a higher maintenance margin of 30% or 40%.
Pros
- Enables buying securities with borrowed funds
- Leverage amplifies gains, potentially leading to significant profits
Cons
- Incurring debt that needs repayment
- Risk of facing margin calls during stock value drops, requiring immediate cash
Advantages:
In favorable conditions, margin trading promises considerable returns. If JNJ rises to $150 per share, Sheila’s 1,000 shares would value at $150,000. Post-loan repayment of $50,000, she nets $100,000. Investment-wise, Sheila’s ROI is 100%, equating to an additional $50,000 on her $50,000 investment.
Comparatively, investing exclusively with a cash account (without borrowing) means Sheila invests the full $100,000. A price rise to $150 gets her a 50% ROI—the same $50,000 profit, but all her own money was initially allocated to this investment.
In this example, margin trading allows higher returns by committing half the original capital, facilitating other potential investments. This underlines the core trade-off in leveraging—higher rewards but elevated risks.
How Long Do You Have to Answer a Margin Call?
Typically, brokerage firms grant a window of two to five days to meet the cash deposition requirements following a margin call, as stipulated by FINRA.
How Much Money Do You Need to Trade on Margin?
For non-day traders, FINRA sets a minimum requirement of $2,000 or 100% of the purchase price, whichever is lower. For Pattern Day Traders, the minimum deposit peaks at $25,000.
What Is a Pattern Day Trader?
A Pattern Day Trader, per FINRA, is someone executing four or more day trades within five business days, provided it exceeds 6% of the account’s total trades in the same period. Brokerages might adopt broader definitions to classify pattern day traders.
The Bottom Line
Trading on margin can amplify successful stock buys but carries the risk of requiring swift cash injections to avert forced stock sell-offs. While promising for the astute and fortunate, margin buying demands ample liquidity and can cater to investors resilient against potential losses.
Related Terms: debt, trading on margin, broker, margin account, initial margin, maintenance margin.
References
- U.S. Securities and Exchange Commission. “Margin: Borrowing Money to Pay for Stocks”.
- Federal Reserve History. “Stock Market Crash of 1929”.
- Financial Industry Regulatory Authority. “Know What Triggers a Margin Call”.
- Financial Industry Regulatory Authority. “Brokerage Accounts: Margin Accounts”.
- U.S. Securities and Exchange Commission. “Investor Bulletin: Understanding Margin Accounts”.
- U.S. Securities and Exchange Commission, Office of Investor Education and Advocacy. “Margin Rules for Day Trading”.
