What You Should Know About Trading on Margin
Trading beyond your capital is possible by using margin. This tried and tested technique is attractive and used by many, but it’s important to understand that it involves much greater risk.
Margin is a double-edged sword, because it can amplify gains as well as losses. It’s a great tool if you’re on the right side of a move, since you can make a large profit with very little cost to you. But it can be disastrous if you get caught on the wrong side, especially in a fast-moving market.
What Is Margin?
In its simplest form, trading on margin is using borrowed money to buy a security. Have you ever bought a car using a loan? Well, trading on margin works in a similar way, except that you can take advantage of the effect of leverage and thus increase your potential profits.
Margin trading is basically buying with borrowed money. You borrow money from a broker and this borrowed money allows you to buy more stocks (or other financial products) than you could otherwise afford.
Margin trading can be used for any instrument – stocks, crypto, bonds, and so on. However, there is a distinction when it comes to futures. Futures trading uses margin slightly differently. In those cases, you do not own the asset you are borrowing money for, as you do a car or a house. Also, with futures you do not pay interest on the amount you have borrowed, instead a portion of your cash is set aside by the broker to act as collateral.
How Much Margin Can I Use?
Like getting a loan for a car or a house, it depends on different factors. Among these, the type of instrument is the most obvious: different instruments will have different margin requirements.
Rules-Based or Risk-Based
The second consideration is whether you, or your broker, are operating in a country where the regulations relating to margins are “rules-based” or “risk-based”.
When it comes to the US, the approach is mostly, but not on all exchanges, rules based. This means a fixed percentage is applied to the market value to decide the amount of the margin. The US Regulation T Rules state that, for buying stocks in margin, traders can borrow no more than 50% of the price of shares. In addition, FINRA, the brokerage and markets regulator, imposes further requirements.
However, in other countries and on some US exchanges for certain instruments, it is risk-based. This means that instead of a fixed percentage, your portfolio is evaluated, and your margin requirements are set using simulated market movements covering worst case scenarios. This means that margin requirements are not fixed.
It’s Also Risky for the Lender
Ultimately, the broker is taking the risk by lending to you. They need to protect themselves from market risk and credit risk, where one or more of borrowers fail or refuse to meet their financial obligations to the broker.
Thus, to cover themselves, they have the right to increase margin requirements, that is to say decrease the amount you can borrow, or even choose not to open margin accounts.
You will need to open a separate margin account: trading on margin is not possible with just a cash account. You will also need to consider the following:
- Initial margin – the amount in the margin account that the broker lends against. So, for example if you are in the US and if you are buying stocks that will be 50%, or higher depending on the brokers requirements. In other situations, this may be much lower.
- Maintenance margin – the minimum amount that must be in the margin account. This is a sort of safety net for the broker and a reasonable guide is 25% of the value. Brokers also have the right to institute margin calls if this maintenance margin falls below a certain percentage. This means they can liquidate your position.
- Interest and any fees.
Golden Rule: The securities you buy on margin should, at a minimum, have the potential to earn more than the cost of interest on the loan.
Most brokers have calculators and online tools that you can use for setting up margin accounts and for monitoring them.
When Things Go Right… and Wrong
As mentioned above, by trading on margin, you take advantage of leverage. This is very beneficial when things work out, much less so when they do not.
- You buy a stock for $50, and the price of the stock rises to $75. You’ll earn a 50% return upon squaring off your position
- But if you bought the stock in a margin account – paying $25 in cash and borrowing $25 from your broker – you’ll earn a 100% return on your invested money, excluding the interest cost.
- In this case, your $25 gain is 100% of your initial investment of $25.
Conversely, when you trade on margin, your losses can mount up quickly.
- Let’s say the stock you bought for $50 falls to $15
- If you paid $50 cash, you would lose 70% of your money
- However, if you bought on margin, you would lose more than 100% of your money
- In addition to the 100% loss of your $25 initial investment, you would also owe your broker an additional $10 plus the interest on the margin loan
- In this case, you will owe more money than your initial stake.
Furthermore, losses like these will also result in a margin call from your broker. You are now expected to increase the amount in your margin account. You can do this in two different ways:
- Deposit additional cash or securities
- Sell any other securities you may have to generate cash.
In the worst case your brokerage firm may sell some or all of your securities without consulting you.
A worthwhile tool, used wisely
To sum up, margin trading allows you to use your broker’s money and earn comparatively higher returns. It is a valuable technique, but you need to understand it first.
Additionally, understanding margin accounts and margins is required if you want to use short selling or advanced options strategies.
Margin trading is a double-edged sword. Make sure you fully understand it and take the time to learn the risks. One easy way of doing this is to use the simulation mode in Bookmap.