What is Margin Debt
Margin debt is debt a brokerage customer takes on by trading on margin. When purchasing securities through a broker, investors have the option of using a cash account and covering the entire cost of the investment themselves, upfront, or using a margin account, meaning they borrow part of the initial capital from their broker. The portion the investors borrow is known as margin debt; the portion they fund themselves is the margin, or equity (not to be confused with the securities the customer is trading, which may themselves be equities).
BREAKING DOWN Margin Debt
Margin debt can be used when borrowing a security to short sell, rather than borrowing money with which to buy a security. As an example, imagine Sheila wants to buy 1,000 shares of Johnson & Johnson stock for $100 per share. She doesn't want to put down the entire $100,000 at this time, but the Federal Reserve Board's Regulation T limits her broker to lending her 50% of the initial investment. Brokerages often have their own rules regarding buying on margin, which may be more strict than regulators'. She deposits $50,000 in initial margin while taking on $50,000 in margin debt. The 1,000 shares of Johnson & Johnson she then purchases act as collateral for this loan.
Risks of Margin Debt
Two scenarios illustrate the potential risks and rewards of taking on margin debt. In the first, Johnson & Johnson's price drops to $60. Sheila's margin debt remains at $50,000, but her equity has dropped to $10,000. The value of the stock (1,000 × $60 = $60,000) minus her margin debt. The Financial Industry Regulation Authority (FINRA) and the exchanges have a maintenance margin requirement of 25%, meaning that customers' equity must be above that ratio in margin accounts.
Falling below the maintenance margin requirement triggers a margin call unless Sheila deposits $5,000 in cash to bring her margin up to 25% of the securities' $60,000 value, the broker is entitled to sell her stock (without notifying her) until her account complies with the rules. This is known as a margin call. In this case, according to FINRA, the broker would liquidate $20,000 worth of stock rather than the $4,000 that might be expected ($10,000 + $4,000 is 25% of $60,000 – $4,000). This is due to the way margin rules operate.
Rewards of Margin Debt
A second scenario demonstrates the potential rewards of trading on margin. Say that, in the example above, Johnson & Johnson's share price rises to $150. Sheila's 1,000 shares are now worth $150,000, with $50,000 of that being margin debt and $100,000 equity. If Sheila sells commission- and fee-free, she receives $100,000 after repaying her broker. Her return on investment (ROI) is equal 100%, or the $150,000 from the sale less the $50,000 less the $50,000 initial investment divided by the initial $50,000 investment.
Now let's assume that Sheila had purchased the stock using a cash account, meaning that she funded the entire initial investment of $100,000, so she does not need to repay her broker after selling. Her ROI in this scenario is equal to 50%, or the $150,000 less the $100,000 initial investment divided by the $100,000 initial investment.
In both cases her profit was $50,000, but in the margin account scenario she made that money using half as much of her own capital as in the cash account scenario. The capital she's freed up by trading on margin can go towards other investments. These scenarios illustrate the basic trade-off involved in taking on leverage: the potential gains are greater, as are the risks.