Trading on Margin – The Double Edged Sword

By January 11, 2016 Newsletter No Comments

Trading on margin means trading stocks by making a down payment (margin) and borrowing the balance from your broker. Before you trade on margin you need to have margin account with the broker. Unlike cash account, where you trade using your own money, trading on margin means putting some cash of your own and some borrowed from broker.

The margin account allows for borrowing against the stocks, meaning you can buy more than you are actually able to. Broker charges certain interest on the loan he gave you.

Generally the following formula is used in calculating the interest charges:

(Interest Rate/365 Days)*(Amount Being Borrowed)*(Number of Days Borrowing Funds)

Different brokers charge different interest rates and traders should inquire from their brokers.

The good news is that you can keep the loan as long as you want, if you fulfill all the obligations on time. Nevertheless, it is recommended that you borrow for a very short period. If you borrow for too long, then you have to pay higher interest charges and this means your trade has to earn greater return in order to just break even. Paying interest eats into your profits.

You should know, however, that not all stocks can be bought on margin. That is why you need to research each stock and get advice from professionals.

Three Types of Margin Requirements

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Before opening the margin account, there are a few requirements that you need to meet. These are margin requirements that present the margin-able reassurances that must be paid by the investor, for his or her cash. They are set by the Federal Reserve Board, FINRA, and the broker. However, the broker can change them, and set his own rules.

There are Three Types of Requirements:

1 – Minimum Margin

2 – Initial Margin

3 – Maintenance Margin

In order to open the account on margin, FINRA requires you to deposit with your brokerage firm a minimum of $2000 or 100 percent of the purchase price of the securities, whichever is less. This is known as the “minimum margin.” Some brokers may require you to deposit more than $2,000.

According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of equity securities that can be purchased on margin. This is known as the “Initial Margin”. Some brokers may require you to deposit more than 50 percent of the purchase price.

Once you purchase the securities on margin, FINRA imposes “maintenance requirement” on your margin account. The “maintenance requirement” means that you must maintain certain minimum amount of equity in your margin account at all times. The equity is calculated as follows:

Equity in Your Account = Value of Your Securities – Amount you Owe to your Broker

FINRA requires that your equity (maintenance requirement) should be at least 25 percent of the total market value of the securities purchased on margin.

Some brokers require higher maintenance margin such as 30 to 40 percent. The maintenance margin is also based on the volatility of the stock. Volatile stocks have higher maintenance requirement than less volatile stocks.

The following example will help you understand how maintenance requirements work.

Let’s say you purchase $36,000 worth of AAPLE (AAPL) stocks by borrowing $18,000 from your brokerage firm and paying $18,000 in cash. (Instead of paying cash you can also put your other securities as collateral).

If the market value of the AAPL stock drops to $30,000, the equity in your account will fall to $12000

Equity in the account = $30000 – $18000 = $12000

Let’s say your brokerage firm has 25% maintenance requirement then you need to have $7500 equity in your account ($30,000*25%). Since the equity in your account is $12,000, it means you have enough equity to meet the maintenance requirement.

However, if your broker requires to have 45% maintenance requirement then you need to have $13,500 ($30,000*45%) as equity in your account. Since you only have $12,000 equity, therefore, you will receive a “margin call” from your broker to deposit additional $1500 in your account by certain day and time. If you do not meet the margin call by the designated date and time then your equity will be liquidated. If the stock is volatile and falls further then broker will liquidate your account without waiting for you to deposit additional funds. So, be wary of this possibility and never ignore the margin call. This usually happens when market is moving against you fast. There is no time for the broker to inform you about meeting the margin call.

The Pros and Cons of Trading on Margin

As with everything in life, there is a good and a bad side to margin trading. The pros of this type of trading is that it boosts your purchasing power. This is due to the borrowing from your broker. Another advantage is that you can bet against stocks by shorting the stock. You can also adopt various options trading strategies which are not available in cash account.

The disadvantage of margin trading is that when stock goes against you then you have to deposit additional funds by certain date and time. If you do not have additional funds then your holdings will be liquidated by your broker no matter what. Sometimes as mentioned before, you do not even receive margin call from your broker as stock is moving fast against your predicted direction and broker is concerned with protecting his own capital. With margin trading, you are dealing with double-edged sword.

Day Trading on Margin

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Day trading means buying and selling the same security within a single trading day. It is most common in stocks, futures and foreign-exchange markets. Day traders usually trade same instrument multiple times in a single day. Due to their frequency of trading these traders are classified as “Pattern day Trader”.

According to Wikipedia “Pattern day trader is a term defined by FINRA to describe a stock market trader who executes 4 (or more) day trades in 5 business days in a margin account, provided the number of day trades are more than six percent of the customer’s total trading activity for that same five-day period.”

When we combine day trading with margin trading the combination becomes more profitable but more risky.

According to FINRA rules, “a pattern day trader must maintain minimum equity of $25,000 on any day that the customer day trades. The required minimum equity must be in the account prior to any day-trading activities. If the account falls below the $25,000 requirement, the pattern day trader will not be permitted to day trade until the account is restored to the $25,000 minimum equity level.”

The pattern day trader can trade up to four times the maintenance margin excess in the account as of the close of business of the previous day.

If the pattern day trader exceeds the day-trading buying power limitation, the brokerage firm issues a day-trading margin call to the pattern day trader. The pattern day trader then have five business days to deposit the funds to meet this day-trading margin call. Until the margin call is met, the day-trading account is restricted to day-trading buying power of only two times maintenance margin excess based on the customer’s daily total trading commitment. If the pattern day trader does not meet the day trading margin call by fifth business day then his account is further restricted for trading only on cash basis for 90 days or until the margin call is met.

In summary, before trading on margin basis, a trader should research thoroughly and obtain all the necessary information from his broker. Trading on margin is not for everybody. It is a double-edged sword!

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