Trading Margin is a fancy word for – loan from your brokerage.
Most people associate loans with debt and therefore want no part of it.
But, there is an advantage to use margin versus a cash account, even if you don’t want the extra money. Some trades can only be traded on margin accounts, without margin you miss out on a wide variety of option strategies. This can’t be.
Margin also allows you to avoid the delay in trade settlements, which means you can trade faster instead of having your money tied up.
With the good, there must be some bad. Margin has fees and requirements that you need to be aware of. Along with margin, you are also hit with terms such as initial margin, margin call, and maintenance margin. You will need to know these terms mean.
We will show you how to navigate all things margin and how to use it to your advantage while keeping your portfolio safe.
Definition Of Margin Trading
Investopedia defines margin trading as, “Buying on margin is borrowing money from a broker to purchase stock.”
For a typical stock, brokerages will allow you to borrow up to 50% of the cost.
You open a new margin account at your brokerage with $5,000. Your buying power will be double, $10,000. If you buy $5,000 worth of stock, you still have $5,000 to spend. This is the power of trading on margin.
Do you need good credit to use margin in your trading? No.
Brokerages, by law, require a minimum of $2,000 in your account to open a margin account. At all times, you must meet this minimum requirement. You will also be required to fill out a special form before opening your new account. The reason your credit history is not a concern is that your margined securities will be used as collateral.
What Initial Margin, Maintenance Margin, and Margin Call Mean
Initial margin is the original amount you borrow in your trade.
For example, The Option Prophet (sym: TOP) is currently trading at $20 a share. You decide to use your margin account to purchase 1000 shares. The total cost of the investment is $20,000. Due to margin, you use $10,000 in cash and borrow the other $10,000 – this is your initial margin.
Maintenance margin is the minimum amount of money you need to have in your account to continue with your current position. Typically, this level is set at 25%.
Using the example above. You have 100 shares of TOP at $20 a share. The price begins to drop and falls to $15 a share. Your account is now worth $5,000.
Current Value – Initial Margin = Account Value
15,000 – 10,000 = $5,000
Maintenance margin is calculated by taking the current value of the position and multiplying it by 25%.
15,000 x 25% = $3,750
Your $5,000 account value is above the maintenance margin, good. But, what happens if TOP drops to $12 a share?
Account Value = $2,000
Maintenance Margin = $3,000
At this point, your brokerage would issue you a margin call. Remember, brokerages need to make sure they protect themselves, they are in business after all. They have set a maintenance margin to make sure you don’t default on your loan to them. This is their minimum acceptable level for allowing this position to continue on.
Once your account falls below the maintenance margin level, your brokerage will issue you a margin call. A margin call is when the broker demands more money or securities to be deposited in your account. You can deposit securities in your account instead of money. The idea is that you want to increase the value of your account so it is above the maintenance margin. You will, typically, be given three days to fulfill the request.
The Advantages Of Margin Trading
Leverage, leverage, and more leverage. Leverage may be a double-edged sword but it does have its advantages.
With leverage, you will be able to multiply your gains. TOP is trading at $10 and you purchase 100 shares. You're using a margin account so you use the $5,000 in your account and $5,000 on margin.
TOP increases to $13 bringing the total value to $13,000. If you were to close the position your account value would increase from $5,000 to $8,000, a 60% increase for a 30% increase in the stock.
Besides leverage, margin opens trading opportunities for you. Without margin, you cannot short a stock.
Tony Sagami said it best, “Short selling is the sale of borrowed stock in anticipation that the stock’s price will decline. If the stock price goes down, the seller buys it back at a lower price and makes a profit.”
Shorting stock is vital if you want to play the market in both directions. A margin account also opens up option strategies.
When looking at your brokerage’s option trading levels, you will notice that only the purchasing of options is open in the first couple of levels. When you want to unlock strategies such as bull put spreads, bear call spreads, iron condors, etc... you will need to open a margin account.
One of the hidden aspects in brokerages that new traders discover is settlement days. When you trade a position, it takes 3-days to actually settle the funds. If you are holding TOP and sell it on Monday, the funds wouldn’t actually settle until Thursday.
Why does settlement matter? Because there are settlement violations that your brokerage can hit you with.
Continuing on with our scenario above. You sell your TOP position on Monday (the funds will settle on Thursday), on Tuesday you buy a position in ABC with those unsettled funds (this is fine, but your brokerage is going to warn you), on Wednesday you sell your ABC funds. This is a Good Faith Violation because you made a complete trade with unsettled funds. Typically, brokerages allow 3 of these violations a year before they place restrictions on your account.
To avoid this hassle and possible restrictions you can use a margin account. Margin accounts do not require 3-days for settlement.
Even if you are not interested in the extra leverage, the additional option strategies, and settlement avoidance make margin very advantageous.
The Disadvantages Of Margin Trading
Leverage, leverage, and more leverage. Leverage is the double edged sword. As easily as you can make gains and increase the return of your portfolio, you can also increase losses to your portfolio.
You own 1000 shares of TOP at $10 a share. The total position value is $10,000, half of that is with cash and the other $5,000 is on margin. If TOP decreases to $7 your account value is now $2,000, a loss of 60%. This is a large loss considering the stock only dropped 30%.
Along with leverage, margin accounts can make it difficult for long-term position holders. If you plan to hold a position over a year, you expect to go through the lows and highs of your position. The problem, if the underlying drops too far, or your account value drops too far, you could fall below the maintenance margin level and be issued a margin call, forcing you to close your position before you’re ready.
Once you open a margin account, you are inviting your brokerage into your portfolio. If you fail to meet a margin call, that is, failed to increase your account value in the three days following the call, your brokerage will come in and start selling any securities that have been purchased on margin to meet the call. This is done to make sure you can pay for your loan and it doesn’t put the brokerage on the line for your debt.
No loans are free, that includes margin. Your brokerage will charge you interest anytime you have a trade on that uses margin. Typically, this interest level is so small that it is negligible, but it does need to be noted that it will cost you to use margin. All brokerages list their interest charges in their fee schedules.
Options And Margin
When it comes to options and margin, you will hear two conflicting and confusing tales. First, options don’t trade on margin. Two, some option strategies require margin.
Conflicting? Yes. Confusing? Yes. But true? Yes.
Options already have a lot of leverage embedded in them. This is one of the draws to options. So brokerages will not allow you to buy options on margin. If you have a $5,000 account and another $5,000 in margin, you can only use your original $5,000 to purchase options.
A lot of brokerages will list your Stock Buying Power and Option Buying Power as two separate numbers to alleviate this confusion.
Option strategies that are traded for a credit do require margin. Credit strategies don’t require you to pay anything to the broker, in fact, they will pay you the credit. However, they do need some collateral in case the trade turns against you. For collateral the brokerage uses margin. As discussed, the margin used is determined through set formulas.
What Is Portfolio Margin
Up until now, we’ve been dealing with Regulation T margin. For more sophisticated portfolios there is Portfolio Margin. Sophisticated because brokerages will require $120,000 account value before granting Portfolio Margin.
The main difference between the two is how they calculate the required margin for positions. Regulation T follows a very defined formula for applying regulation.
For example, you want to trade a bull put spread by selling the 65 strike and buying the 60 strike for a credit of $1. Your margin would be $40.
Margin calculation: Strike 1 – Strike 2 – Credit
65 – 60 – 1 = $4 = $40
Portfolio Margin doesn’t follow this formula. Instead, your portfolio will be put through a stress test every day, and the maximum loss found by the stress test will be your margin requirement. This will typically result in a lower margin requirement versus Regulation T accounts. Portfolio Margin is a great way to use the money in your portfolio efficiently.
Margin is an excellent resource to have as a trader, but it needs a careful touch. You can have the leverage work in your favor and increase the gains in your portfolio exponentially, but it can also quickly turn against you and take those gains away.
This doesn’t mean it should be avoided entirely. You can trade on margin without risking large amounts of money. Being on a margin account brings you the benefit of no fund settlement dates and a wide variety of trading strategies.
If you are a sophisticated trader with a large portfolio the move to Portfolio Margin can help you make the most use of your capital.
What benefits do you see in a margin account? Tell us in the comments...