Buying on margin is a trading strategy that involves borrowing money from a brokerage to purchase investment assets (usually a security like stocks or bonds). It amplifies your buying power, allowing you to invest more and potentially earn greater returns: even though all the money you’re investing isn’t yours, the gains that may come with it are.
Margin trading comes with costs and risks, of course. You pay interest on the money you borrow. The amount borrowed is represented as a negative (debit) cash balance in your account. If your investment goes down, you lose money at the same amplified scale. If things really go south, you could lose more money than your initial investment. That makes buying on margin a higher-risk strategy.
The actual “margin” in margin trading is the amount of money you need to deposit in order to borrow money from your brokerage. So if your brokerage requires a 30% margin and you want to purchase $10,000 worth of a security, you would need to fund your account with at least $3,000. The brokerage would lend you the other 70% and charge you interest on the loan. With all margin purchases, the brokerage holds the securities as collateral. When you close your position, the brokerage pays themselves back before sending you any profit.
What is a margin account?
You can’t trade on margin with a registered account (like a TFSA or RRSP) or even a non-registered account. You need a special account called a margin account, which lets you borrow money to buy securities and perform certain kinds of trades, like short selling and complex options.
Because buying on margin is a higher risk investment strategy, you’ll need to apply for a margin account. Brokerages often need more information or have higher requirements with margin accounts than with other investment accounts.
How do I trade on margin?
Step 1: Open and fund your account
After opening your margin account, you’ll need to fund it. Most margin accounts have minimum funding requirements, although the specific amount can vary. You’ll need to fund your account by depositing cash or transferring in margin-eligible securities (typically stocks that trade on major indices for over a certain price; penny stocks, for example, are not eligible).
Step 2: Determine your buying power
The equity in your account and the margin requirements of the brokerage determines your buying power: the total you have available to purchase securities at a 100% margin rate. In the example above, if you funded your account with $3,000 and your brokerage requires a 30% margin, you would have a maximum buying power of $10,000 (your $3,000 + their $7,000) — although you don’t have to use it all.
Step 3: Make a purchase
Once you make a purchase, you start owing interest on the money you borrowed to do so. The amount of interest you pay is based on the interest rate, the amount borrowed (negative cash balance), and the length of time you borrow the money. For tax purposes, in Canada, you can deduct the interest paid from the gains and losses in your account.
Step 4: Maintain your account
You must maintain the minimum buying power in your account at all times. Dips below the maintenance margin usually occur when the value of the securities in the account decreases. If that happens, your brokerage will issue a margin call. (See below.)
Step 5: Sell your position
When you instruct your brokerage to sell your position, it will sell the securities for you, pay itself back the outstanding loan value and any interest charges, and pass the remaining balance on to you. If the stock price went up while you were invested, you’ll generally make a profit. If it went down, you won’t. Your losses will come out of the equity in your account. If your losses are greater than the equity in your account, you will need to add funds or margin-eligible securities to the account to cover the amount owed. If you want to repay the loan before you sell the position, you can deposit funds and or margin eligible securities to your account. You will need to deposit enough funds to change your cash balance from a negative to a positive position (debit to credit).
What is a margin call?
If you fail to maintain the required margin in your account, your brokerage will issue a margin call. A margin call requires you to fund your account, which can be done in various ways. Some ways of funding your account include: selling securities in the account or transferring cash or margin-eligible securities to your account to bring it back up to the maintenance margin. If you don’t bring your account balance up by the specified time frame determined by your brokerage, they may liquidate your securities.
Examples of buying on margin
Let’s say you funded a margin account with $5,000, and the margin requirement is 50%. That means you can borrow another $5,000, giving you a maximum buying power of $10,000. You’ve been keeping a close eye on a certain stock, and you think there’s a pretty good chance it’s going to increase in value in the short-term.
Scenario 1: the stock price goes up
You buy $10,000 worth of the stock. A week later, the stock increases in value by 5%, giving you $500 in returns. You sell the stock and pay back the $5,000 you borrowed, netting a profit of $500, minus any interest on the loan.
If you didn’t buy on margin, and instead made the investment using only the $5,000 of your own money, your returns would have been $250.
Scenario 2: the stock price goes down
If that same stock had dropped in value by 5%, your investment would drop in value to $9,500. When you sell the stock and pay back the $5,000 you borrowed, you are left with $4,500, minus any interest on the loan. So you lost about $500.
Had you not bought on margin and instead invested only your $5,000, you would have lost half that, or $250.
How much loan value can I get in my margin account?
If margin is the amount you need to deposit, loan value is how much you can borrow against that security (if eligible). How much loan value you can get (which is to say, how much money you can borrow) depends on a few different factors:
Regulatory bodies. The Canadian Investment Regulatory Organization (CIRO) sets minimum requirements for securities that can be bought on margin. Those numbers can change, depending on how a specific security is performing. The margin rate depends on the type of the security. Relatively low risk bonds can have a low margin requirement as little as 1%. Typically investors can borrow up to 70% for equities.
The price of the stock itself. How much a stock is valued for can impact how much loan value you can get for it. For example, if an equity is trading at $2 or more, the minimum margin rate required by CIRO is 50%. So, to figure out how much you can borrow against a security you’ll need to figure out the market value of the trade and multiply it by the number of shares you want to purchase, and then subtract the margin rate. Let’s say you’re looking to buy 10 shares at $2 a share, and want to know your loan value:
Market value: 10 shares x $2 = $20 Net loan value: $20 x (1-0.50) = $10.00
This means the amount you can borrow $10 against that stock.
Keep in mind, the loan value fluctuates based on the market price. So in our scenario above, if the share price increases to $4, you now have $20 in loan value. But if it drops below $1.50, the minimum margin rate required by CIRO is 100% so you wouldn’t be able to borrow against it anymore.
You. Generally speaking, the more equity you have in your margin account, the more you can borrow. You can increase your loan value by depositing additional funds or marginable eligible securities to your account.
It’s important to remember: brokerages can also set their own initial margin requirements, as long as they’re higher than the minimums established by CIRO. They might also set an overall limit on how much you can borrow or a limit for how much you can borrow on a single security, which is known as a concentration limit. These limits may be based on your financial situation, portfolio, or firm policy limits.
Benefits of using margin
There are three key benefits of buying on margin:
Greater potential returns. Buying on margin increases your buying power, which could potentially increase your returns. If you can invest $10,000 instead of $5,000, and the security you purchase goes up in value, you double your profits.
Flexibility. Buying on margin allows you to move quickly to take advantage of timely market opportunities that you might otherwise miss out on by not having enough cash or liquid assets.
Access to cash. With a margin account, you can withdraw funds against your assets as long as there is available margin to do so. This is similar to a secured line of credit, using your securities as collateral. This is often cheaper and provides quicker access to cash than other types of loans. Withdrawn money is not taxed and interest charged is tax-deductible.
Risks of buying on margin
On the flipside, there are a few big risks of buying on margin:
Greater potential losses. Buying on margin can open up the potential to lose more money than your initial investment. The same leverage that magnifies your gains can also magnify your losses. If you buy a security and its price falls, not only will you lose your initial investment, you’ll also still need to repay what you borrowed - whether that’s dipping into other savings or investments, if you have them, or finding other means to repay the loan.
Cost of interest. As with any loan, the the more you borrow, the more interest you’ll have to pay.
Margin calls. If your account falls beneath the maintenance margin, you’ll receive the dreaded margin call, requiring you to add more cash or margin-eligible securities to your margin account (or sell some of your positions) to bring your buying power above zero. If you don’t, the brokerage can sell some or all of the securities in your accounts based on the agreements you signed when you opened your account.
Is margin trading for you?
The extra buying power can create opportunity, but the losses can be serious, which is why margin trading is an investment strategy that should only be used by experienced investors with a high risk tolerance. If you want to begin margin trading, make sure you understand the potential consequences.
