Margin for long-term stock investors

Margin for long-term stock investors

Trading stocks on margin is typically governed by Regulation T (Reg T2), under which an investor can borrow up to 50% of the purchase price of securities. This is also known as "initial margin," as some brokerages require a deposit greater than 50% of the purchase price. However, exchanges and brokerages can establish their own margin requirements as long as they're at least as restrictive as Reg T, according to the U.S. Securities and Exchange Commission.
For example, suppose an investor wants to buy 1,000 shares of a stock trading at $20, or $20,000 worth, but has only $10,000 available to invest. With margin, they can borrow an additional $10,000 and purchase all 1,000 shares.
If the stock rises from $20 to $25 a share (a gain of $5 per share, or $5,000), there's a 50% profit because the gain is based on the $10 a share paid with cash and excludes the $10 a share paid with funds borrowed from the broker.
However, if the stock dropped to $15 a share, it becomes a loss of 50%—double what the loss would be if the stock was paid entirely in cash. Moreover, it could lead to a margin call.
As with any loan, when traders buy securities on margin they have to pay back the money borrowed plus interest, which varies by brokerage firm and the amount of the loan. Interest accrues daily at the prevailing rate and is deducted from a trader's account on a monthly basis.
Margin interest rates are typically lower than those on credit cards and unsecured personal loans. There's no set repayment schedule with a margin loan—the principal can be paid down any time. However, there are monthly interest charges that continue to accrue to the account until the principal is paid off. It's important to note, too, that those rates may fluctuate.
Also, margin interest may be tax deductible if used to purchase taxable investments and deductions are itemized (subject to certain limitations; consult a tax professional before proceeding).
As already noted, when used for investing, margin can magnify profits—and losses. While the value of the stocks used as collateral for the margin loan fluctuates with the market, the amount borrowed does not. As a result, if the stocks fall, the equity in the position relative to the size of the margin debt will shrink and could lead to a margin call, increasing the level of market risk.
Traders using margin need to remember that while there's flexibility in paying down the principal of the margin loan, there's no extension of time to meet a margin call.
But margin isn't limited to the long side. Investors with margin privileges can sell stocks short as well, with the aim of making money during, or hedging against, a market decline. Short selling, however, is an advanced trading strategy involving potentially unlimited risks. Consider that when traders buy shares of stock (take a long position), the downside is limited to 100% of the money invested. But when a stock is shorted, its price can keep rising.
In theory, that means there's no upper limit to the dollar amount needed to replace the borrowed shares. It also means there's no guarantee the broker can continue to maintain a short position for any period of time and may close out the position without regard for loss or profit.