A margin trade is one where the trader uses other securities or cash as collateral, for a transaction in which he or she has not purchased the security outright.
The broker acts as a lender. If your broker approves you for a margin account, you have the ability to purchase new securities “on margin” by using your current holdings as collateral, or by depositing 50% (or more depending on the broker) of the market price of the security into the margin account.
Once the securities have been acquired, the broker and investor have an agreement that the investor will maintain at least 25% (or 30% more often) of the equity required in the account, knowing that the value of this equity will fluctuate as market prices change. Some other terms associated with margin trading are “maintenance margin” and a “margin call.”
The minimum amount of equity required to be in the account at all times is called the “maintenance margin.” A “margin call” occurs when the value of the equity slips below the maintenance margin percentage, and the broker requires that more equity is deposited immediately.
An investor must understand that in the case of a margin call the broker reserves the right to sell enough securities to cover the margin call. Since the investor only had partial equity in the shares to begin with, this can mean enduring a significant loss.
An investor could also deposit cash to satisfy the call, or deposit securities they may hold in another account. Often times, however, in the case of securities, the investor would have to deposit 125% (or more) of the market value of the securities, and not all securities are margin-able.
Margin trading is all about leverage, and if the securities purchased on margin generate positive returns, it can accelerate an investor’s total return. For some investors, it can also mean buying additional securities even if they don’t have cash readily available, which means they won’t have to sell securities to raise cash (and thus could be avoiding capital gains).
Of course, the flip-side of buying on margin is the risk of the securities losing value, which means an investors downside can be exacerbated greatly. Also of note is that buying on margin means paying interest on the loan, so the gains from the securities purchased have to outweigh the interest paid for the transaction to make business sense.