Stocks course · Section 5: Risk, Leverage and Testing
Margin Trading and Short Selling: How Leverage Works in a Stock Account
How buying on margin magnifies gains and losses, how to calculate a margin call, what margin interest costs, and why short selling has unlimited risk.
Advanced6 min read·6:36 video·Lesson 19 of 26·quiz: 4 questions
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A margin account lets you borrow money from your broker, using your shares as security, to buy more stock than your cash alone would allow. That magnifies both gains and losses, costs interest, and if your equity falls below the broker's maintenance requirement you get a margin call and can be sold out at the worst moment. Short selling means borrowing shares and selling them in the hope of buying them back cheaper, with losses that are unlimited in theory. Both are advanced tools, and a beginner should stay in a cash account.
Cash account or margin account?
- Cash account: you can only buy with money you have. The most you can lose is what you put in.
- Margin account: you can borrow against your holdings, and you can sell short. You can lose more than you deposited.
In the US, the Federal Reserve's Regulation T generally lets you borrow up to 50% of the purchase price of eligible stocks, and FINRA rules require your equity to stay at least 25% of the value of long positions (the maintenance margin). Brokers often set higher requirements, commonly 30% or more and much more for volatile stocks, and can raise them without notice. Brokers outside the US follow their own country's rules. US rules for frequent day trading in margin accounts have also been under review, so check your broker's current terms.
How leverage magnifies results
Example
You have $10,000 and borrow $10,000 to buy $20,000 of stock (2x leverage).
- The stock rises 20%: the position is worth $24,000. Repay the $10,000 loan and you have $14,000, a +40% return on your money.
- The stock falls 20%: the position is worth $16,000. Repay the loan and you have $6,000, a -40% return.
Interest comes on top of both.
Calculating a margin call
Your equity is the position value minus the loan. The maintenance rule says equity / position value must stay at or above the requirement.
Example
Using the same $20,000 position and $10,000 loan, with a 25% maintenance requirement: (value - 10,000) / value = 0.25, so value = 10,000 / 0.75 = $13,333. The margin call comes after a fall of about 33%. At that point your equity is $3,333: a one-third fall in the stock has cost you two-thirds of your own money. With a 30% requirement the call comes sooner, at 10,000 / 0.70 = $14,286, a fall of about 29%.
When the call comes, you must add cash or sell. Brokers are not required to wait for you: in fast markets they often sell your shares themselves, at whatever price is available.
Risk
Overnight gaps can skip the margin call stage entirely. If that $20,000 position fell 55% overnight to $9,000, it would no longer cover the $10,000 loan. Your equity would be -$1,000: you would have lost all your money and still owe the broker $1,000.
The cost of borrowing
Margin loans charge interest, usually set as a benchmark rate plus a spread that is often lower for larger balances. Rates differ a lot between brokers and change with interest rates.
Example
At an illustrative 8% a year, borrowing $10,000 costs $800 a year. On the $20,000 position, the stock must rise 4% a year just to pay the interest before you make anything from the leverage.
Short selling: how it works
- Your broker locates shares you can borrow.
- You sell the borrowed shares and receive the cash.
- Later you buy to cover: you buy the shares back and return them.
Example
You short 100 shares at $50 and receive $5,000.
- The stock falls to $40. You buy back for $4,000: profit $1,000.
- The stock rises to $80. You buy back for $8,000: loss $3,000.
- The stock rises to $150. You buy back for $15,000: loss $10,000, twice the value of the original sale.
The asymmetry is the key point: the most you can make is 100%, if the stock goes to zero, but there is no ceiling on the loss.
The extra costs and risks of shorting
- Borrow fees. You pay a fee to borrow the shares. For most large stocks it is small, but for "hard to borrow" stocks it can be very high.
- Dividends. While short, you must pay the lender any dividends the stock pays.
- Recall. The lender can ask for the shares back, and if your broker cannot find others, you may be forced to close.
- Short squeezes. When a heavily shorted stock rises, short sellers rushing to buy back push it higher still. In January 2021, GameStop's share price multiplied many times within weeks, inflicting huge losses on short sellers.
- Higher margin. Under Regulation T, shorting needs collateral of 150% of the short's value (the sale proceeds plus 50%), and maintenance requirements for shorts are higher than for long positions.
- Restrictions. Under the SEC's short sale rule, when a stock falls 10% or more from the previous close, short sales are restricted for the rest of that day and the next.
Safer ways to profit from or protect against falls
- Hold cash or reduce positions: the simplest hedge.
- Put options: the most you can lose is the price paid, but options lose value over time.
- Inverse ETFs: easy to buy, but they reset daily and decay over time (see ETFs and index funds).
If you ever use margin
- Write down a maximum leverage, for example total positions no more than 1.25x your equity.
- Know your broker's maintenance requirement for each stock and keep a large buffer above it.
- Size every position from your equity, not from your buying power (see position sizing).
- Never hold a leveraged single-stock position through earnings.
- Include interest in your backtests and in your journal.
Pro note
Leverage does not turn a strategy without an edge into a profitable one. It only makes the result arrive faster, in whichever direction it was going, and it deepens drawdowns. Prove the strategy unleveraged first (see drawdowns and risk of ruin).
Next: how to spread risk across many holdings, in diversification and portfolio construction.
Key takeaways
- Margin is a loan from your broker secured by your shares; it magnifies gains and losses and charges interest.
- A margin call comes when your equity falls below the maintenance requirement, and the broker can sell without asking.
- With 2x leverage, a stock fall of about a third can wipe out two-thirds of your own money.
- A short seller's gain is capped at 100% but the loss has no limit.
- Beginners should use a cash account; anyone using margin needs a written maximum leverage.
Quiz: check what you learned
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