Trading on Margin

Posted on Wednesday, May 22nd, 2019 MarketBeat Staff

Summary - Margin in the context of trading is collateral that a trader supplies to a broker in order to trade currencies, commodities, futures, and marginable stocks. The margin is used, initially, to open a margin account. The margin account is separate from any cash account that an investor has with a broker. This is the account they will use to engage in margin trading using borrowed funds from their broker, called leverage. Trading on margin entails significantly higher risk than investing via a cash account. However, for the right investor, margin trading can have a place in their portfolio.

Margin accounts are required for financial instruments such as commodities and futures. They are also very common in the foreign exchange (forex market) where a large amount of currency needs to be purchased in order to take advantage of very small price moves.

On the one hand, using leverage gives traders the opportunity for significant gains. However, they can also face the loss of their entire investment and more if the trade does not go in their favor. Finding an appropriate risk/reward balance is essential to margin trading.

Introduction

The idea of borrowing money to invest may seem counterintuitive to some investors, and well beyond the risk tolerance of others. However, trading with borrowed money – a concept called trading on margin – is a popular albeit risky investment strategy that allows investors to make a larger overall return than is possible without the borrowed funds.

In this article, we’ll take a closer look at what margin means to an investor and break down the mechanics of opening up a margin account. We’ll also provide examples of how a margin account can work for the benefit – and the detriment – of investors. We’ll wrap up by taking a closer look at both the opportunities and the risks of margin trading.

What does margin mean to an investor?

Margin is the amount of cash that an investor must supply from their own resources in order to initiate a trade via a margin account. The amount of margin will vary depending on the asset or instrument. For example, currency trading (i.e. forex trading) usually requires a margin that is only a single-digit percentage (or less) of the currency’s contract value. It is not uncommon to see leverage ratios of 100:1 or higher as a trader puts up 1% of the contract as margin. On the other hand, stocks that are allowed to be traded on margin, called marginable stocks, require significantly more margin – typically anywhere from 30-50 percent of the value of the transaction. One of the key factors that weigh into this is a stock’s volatility. A higher amount of volatility will require a higher margin percentage.

Margin trading requires that trades set up a margin account with a broker. This is different from a traditional cash account (i.e. a brokerage account). A cash account is the account that an investor will use to buy and sell shares of stocks, mutual funds, ETF's, bonds - essentially any financial instrument where the investor is looking to purchase only a specific amount of that asset (e.g. an investor pays $3,053.00 for 100 shares of stock in AT&T that is trading at $30.53). However, there are some forms of trading, such as short selling, that can only be executed via a margin account. The same is true for assets on the commodities and futures markets.

Because of the risk involved with trading on margin, it is governed by a number of entities including the Federal Reserve Board, self-regulatory organizations (SROs) such as the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA). Each of these organizations has rules for margin trading. One FINRA rule, for example, sets the minimum margin that must be in a margin account before trading can commence as $2,000. The Federal Reserve Board has many regulations including Regulation T which states that an investor’s initial margin must be at least 50% of the purchase price.

How does a margin account work?

A margin account is essentially a secured loan between you and your broker. In the case of a margin account, the initial investment (margin) that investors provide to secure the loan serves as collateral for the loan. The minimum margin required to open a margin account is $2,000, however, some brokers will require more. By law, a broker must get their client's signature to open a margin account. Once the account is open, a trader can borrow up to 50% of the purchase price of the security or asset being traded. The percentage they invest from their margin account is the initial margin. For marginable stocks, that carry more risk of loss, a broker may require you to put up the full 50% and in some cases, they will require additional margin. But the majority of trades will not require a trader to put up the full 50%. In fact, in some cases (e.g. currency trading), a trade can be established with an initial margin of as little as 0.25%. For example, a trader may take a 1:100 position on a $100,000 trade between a currency pair such as the European Euro (EUR) and the (USD), by receiving a $100,000 loan from their broker. They would then pledge $1,000 from their margin account as the initial margin. This type of leverage is common in currency trading because traders want to buy a large amount of currency to benefit from what are typically very small price movements.

Trading on margin is primarily an investment strategy that is used for short-term investments. This is because the longer a position is open, the greater the return that is needed to break even, and therefore the odds of making a profit decrease significantly. That being said, once a trade is executed, there is no time limit for closing a position as long as the margin requirements are met. This means, among other things:

If a stock is sold, or a position closed, the proceeds (i.e. profits) will first go to your broker to repay the loan. This will continue until the outstanding balance is paid off.

A trader must maintain a maintenance margin, which is a minimum account balance that must be maintained. If it is not, the broker will issue a margin call, which will require investors to deposit more funds into the account. This may take the form of selling other stock in the margin account.

Traders will have to pay interest charges on the loan. These will be applied directly to the account, but can be paid separately by the investor. If the interest charges are applied to the account, the level of debt increases which also increases your interest. This debt cycle can if not properly managed, lead an investor to fall below their maintenance margin.

Let’s take a look at a couple of examples of how margin accounts work.

Example A: Linda purchases $10,000 of stock without margin. So on the other hand, purchases $10,000 of the same stock, but uses her margin account to purchase an additional $10,000 of the stock by borrowing from her broker. Let's look at what will happen assuming the shares increase in value by $50 in six months.

           

Linda

Sue

Cash Available

$10,000

$10,000

Margin Loan (50%)

$0

$10,000

Stock Price

$100

$100

Shares Purchased

100

200

Total Outlay

$10,000

$20,000

Shares increase in value to $150 after six months

Stock Price

$150

$150

Share Sale Proceeds

$15,000

$30,000

Gross Gain (w/o commissions)

$5,000

$10,000

Interest on Margin Loan @ 8.5%

0

$425

Net Gain

$5,000

$9,575

Return on Investment

50%

95.75%

Notice how Sue gets a nearly 50% larger net gain despite having to pay back the premium on her margin loan ($10,000) and interest ($425). That’s the benefit of leverage. Now let’s look at an example that shows the risks involved.

Example B: John opens a margin account with $5,000 of his own funds and $5,000 borrowed from his brokerage as a margin loan.  He then buys 200 shares of a marginable stock that costs $50/share and is required to put up 50% of the cost ($5,000) as an initial margin. If the maintenance margin requirement (MMR) is 30%, this is what could happen to John’s account under different conditions.

Current Stock Price

Account Value (A)

Margin Loan (B)

Account Equity
(C = A-B)

MMR
(D = 30% x A)

Margin Excess/Deficiency

(C-D)

$55

$11,000

$5,000

$6,000

$3,300

$2,700

$50

$10,000

$5,000

$5,000

$3,000

$2,000

$45

$9,000

$5,000

$4,000

$2,700

$1,300

$40

$8,000

$5,000

$3,000

$2,400

$600

$35

$7,000

$5,000

$2,000

$2,100

-$100

$30

$6,000

$5,000

$1,000

$1,800

-$800

Note how account equity declines as the stock falls below the initial purchase price. If John were to allow this to continue, it would result in a margin call at somewhere around $35. In this example, the actual price that would trigger a margin call would be $35.71.

Opportunities and advantages of margin trading

Although margin trading does involve risk, it offers opportunities to gain advantages that other forms of trading cannot. Among these are:

  • The opportunity to get leveraged gains– In our Example A (shown above), it’s easy to see how trading on margin can allow an investor to buy more of an asset (shares, currency, etc.) than they could by paying with strictly the cash they have on hand.
  • The opportunity to capitalize on fast-moving trading opportunities – Margin trading lets you make trades when the opportunities present themselves rather than having to wait while raising cash or selling existing securities.
  • The opportunity to diversify- A margin account can help create hedges inside your portfolio that is heavily weighted in only a few stock or sectors. Another form of diversification is by using a margin account to short sell a specific sector or index that you own stocks in, to hedge against a decline.
  • The opportunity to execute “carry” trades– A carry trade is one in which a trader borrows an asset at a low-interest rate and uses those funds to invest in an asset that offers the potential for a higher return. This is prevalent in currency trading.

Risks of margin trading

Every form of investing carries some level of risk, margin trading is no different. It is, however, considered one of the most risky of all investment types for the following reasons:

  • The risk of outsized losses–While margin trading does offer the potential for gains that can’t be achieved without additional leverage, there is theoretically the ability to lose more than 100% of an investment from margin trading. A loss of $10,425 on a $10,000 investment means that a trader loses not only their entire $10,000 investment; they also have to repay an additional $425 loss. However, if the stock drops to zero on a stock that was initially purchased for $50, the total loss would be $20,425. This means the trader has not only lost the full $10,000 investment but will have to repay the brokerage the margin loan of $10,000 plus the interest charge of $425. A debt obligation to a broker is as binding as a debt obligation to any bank or financial institution and must be repaid in full.
  • The risk of a margin call – In Example B above, the chart showed that at a certain point, an asset can drop to a level where the equity in the trade is no longer sufficient to meet an investor’s minimum margin requirement (MMR). When this happens an investor must do one of three things to rectify the deficit in their account: deposit cash in their margin account, deposit marginable securities in their margin account, or liquidate assets worth the amount of the deficiency and deposit the proceeds in the margin account.
  • The risk of forced liquidation - If an investor ignores, is unaware of, or cannot meet the margin call, the broker can liquidate stock as necessary to meet the minimum margin requirement. This can happen without providing the trader with any further notice. If the selling occurs in a market that is declining, the investor may be generating a large loss.
  • The risk of rising interest charges and interest rates – As with any loan, the interest on margin debt continues to add up over time, meaning that the gain will have to be that much greater to make for a profitable trade. Interest rates on margin loans are not fixed so if interest rates rise, so will the interest rate on an investor’s margin loan.

Tips for managing the risks of market trading

While there are risks to margin trading, it is a regulated industry with hundreds of billions of dollars in margin debt on the market at any given time. This means that investors can rightfully view margin trading as a viable opportunity provided they employ some practical strategies to manage risk such as:

  • Only borrow as much as needed– This is true in margin trading as with any kind of lending. No matter how strongly a trader feels about a trade, they should always leave some room in their margin account in case the trade goes against them.
  • Execute short-term trades– The longer an investor stays in a trade, the more likely it is to turn against them. And with interest charges constantly accruing, it will take a much larger gain to remain profitable.
  • Diversify your trades– Just like you would not put all your eggs in one basket in your overall portfolio, traders will want to make sure that their margin trades show diversity. For example, instead of taking a leveraged position on an individual stock, they may choose to use margin for an exchange-traded fund (ETF) that invests in a variety of stocks in a sector. This will reduce their risk of a margin call.
  • Have an exit plan– Margin trading is not a “set it and forget it” proposition. Trading on margin has a narrow margin for error and requires investors to stay on top of their trades and pay attention to market developments, such as earnings reports or the release of economic indicators that can affect them. Also, investors should have a plan for how they will put additional margin in their account, if needed.
  • Be ready to cut your losses– The axiom “pigs get fat, hogs get slaughtered” is very true of margin trading. It can be hard to admit defeat when a trade goes the wrong way, but it’s far better to exit a losing trade and take a small loss, then hold on to the stock with the hope that it will turn around.

The bottom line on trading with margin

When an investor trades on margin they are borrowing money from their broker in order to purchase more of a marginable security. This is a secured loan that takes the form of a margin account which is different from a regular brokerage account in that it allows traders to use the borrowed money as leverage.

Before engaging in market trading, investors should become familiar with both the opportunities and risks involved with this form of investing. Margin trading should only be used for short term trading as the longer money stays in a margin account, the greater the opportunity for a trade to go against the investor which can quickly turn into a downward spiral.

 

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