Margin Trading

Margin trading refers to the practice of using borrowed funds from a broker to trade a financial asset, which forms the collateral for the loan from the broker. Since such use of financial leverage can potentially magnify gains but could also saddle the trader with devastating losses, leverage has the well-deserved reputation of being a double-edged sword. 

Because of the heightened risks of margin trading, it can only be conducted in a type of account known as a margin account, which differs from the regular cash account used by most investors. While stocks can be purchased either in cash or margin accounts, short sales can only be made in margin accounts; as well, certain instruments like commodities and futures can only be traded in margin accounts.

Margin refers to the amount of funds that the trader or investor must personally put up from his or her own resources, and can vary widely depending on the asset or instrument. For instance, currency futures typically need a margin that amounts to a low single-digit percentage of the currency contract’s value. A stock bought on margin generally requires the investor to supply 30% to 50% of the value of the purchase transaction. As a rule of thumb, the greater the volatility of the stock, the higher will be the margin requirement.

Margin trading is risky business, and therefore is governed by rules set by a number of entities – the Federal Reserve Board, self-regulatory organizations (SROs) such as the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority (FINRA), and brokerage firms.

The NYSE tracks the total amount of margin debt – which is debt taken on in a margin account – on the exchange. As of end-September 2017, margin debt on the NYSE was a record $559.6 billion, which is to be expected as U.S. equity indices were also near all-time highs, and stock market peaks and record levels of margin debt often coincide. However, long-time market watchers find it disconcerting that previous peaks in margin debt on the NYSE occurred in 2000 and 2007, a few months before U.S. stocks embarked on major corrections. Very high levels of total margin debt can pose a systemic risk to the economy, because sliding stocks force investors to sell shares to meet margin calls (discussed later here), which exacerbates downward pressure on stock prices and can result in a market crash.

Margin trading is best left to sophisticated traders and high-net worth investors who are conversant with its risks. The average investor will be better off investing for the long term in a cash account, rather than trading for the short-term in a margin account. For those considering margin trading, the risks involved and how to mitigate them are discussed in later sections of this Tutorial.