‘Margin trading’ is a term you will frequently come across in the investment field. It’s an intricate subject; so this article will serve as a guide to illustrating the complexity of this practice.
Breaking down the name
Let’s first dissect the term by describing what ‘margin’ is. It is the money that one borrows from a brokerage firm in order to purchase an investment. It’s also the difference between the total value of securities in an investor’s account and the broker’s loan amount.
The term “buying on margin” refers to borrowing money to purchase securities. The practice typically includes buying an asset in which the buyer pays a percentage of the asset’s value. Furthermore, they borrow the rest from either the bank or the broker. The broker functions as a lender and the securities in the investor’s account are collateral. More on this particular practice will be brought up later.
In the context of business, the margin acts as the difference between a product or service’s selling point and production cost. If not the cost of production, then the ratio of profit to revenue. A margin may also indicate the portion of the interest rate on an adjustable-rate mortgage (ARM) that’s with the adjustment-index rate.
Using margin as a means to purchase securities is like using cash or securities in your account as collateral a loan. The collateralized loan comes with periodic interest that you need to pay. On the other hand, the investor uses money (leverage) that they’re borrowing. In this scenario, both the losses and gains may be amplified as a result.
There are certain cases where margin investing is greatly beneficial. One of which is when the investor anticipates earning a higher rate of return on the investment. What’s more, it’s higher than what they are paying in interest on the loan.
Investopedia editor, Alexandra Twin, further illustrates this by providing a hypothetical situation:
“For example, if you have an initial margin requirement of 60% for your margin account, and you want to purchase $10,000 worth of securities, then your margin would be $6,000, and you could borrow the rest from the broker.”
For the sake of context, ‘initial margin’ means the percentage of the purchase price of a security or a collection of securities. An account holder must pay for this with available cash in the margin account. Alternatively, they can pay with additions to cash in the margin account or any other marginable securities.
In keeping with unraveling the multiple functions of margins, we can now get into dissecting ‘margin trading.’
What does it mean?
This is the practice of using funds one borrows from a broker to trade a financial asset. This forms the collateral for the loan from the broker. As you may recall, such use of financial leverage can potentially amplify gains and create devastating losses. As such, leverage has the reputation of essentially being a double-edged sword.
Due to the risks of margin trading, you can only carry it out on a margin account. This is different from a standard cash account which a majority of investors use. While you can purchase stocks with either cash or margin accounts, short sales are made only in margin accounts.
Likewise, certain types of instruments, like commodities and futures, are only tradable in margin accounts. The margin itself refers to the number of funds that the trader or investor must put up from their own resources. This can vary widely, as it all depends on the asset or instrument.
Currency futures usually require a margin that amounts to a low single-digit percentage of the value of the currency contract. A stock purchased on margin demands that the investor supplies 30% to 50% of the value of the purchase transaction. There’s an easy way to look at this; a general rule of thumb, if you will. The greater the volatility of the stock, the higher the margin requirement becomes.
Rules & Governors
Margin trading is an incredibly risky business. Therefore, it runs on rules that are set by a number of entities. They are…
- …the Federal Reverse Board
- …self-regulatory organizations (SROs), like the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority (FINRA)
- …brokerage firms
The job of the NYSE is to track the total amount of margin debt on the exchange. Margin debt refers to debt that’s taken on in a margin account. Margin debt levels that are extremely high can be a systemic risk to the economy due to sliding stocks. This forces investors to sell shares in order to meet margin calls, which we will discuss later. This intensifies downward pressure on stock prices and could potentially result in a market crash.
With all these risks in mind, margin trading is more suitable for sophisticated traders. This also includes high net-worth investors who have solid experiences with the risks. Average investors are better off investing for the long term in a cash account, rather than a margin account. So generally speaking, margin trading is usually better suited to short term trading.
“Buying on margin”
As previously mentioned, “buying on margin” is borrowing money from a broker in order to purchase stock. Basically, it is a loan from your brokerage. Margin trading lets you buy more stock than you would normally be able to. If you want to trade on margin, you will need a margin account. This, if you remember, is different from a regular cash account, where you trade using the money in the account.
According to the law, your broker needs your signature to open a margin account. An initial investment of about $2,000 is a requirement for a margin account, however, some brokerages will require more. This deposit is the ‘minimum margin’, which is what you need to deposit into a margin account before you trade. Once the account is operational, you can borrow up to 50% of the price for a stock purchase. This specific portion that you go on to deposit is the ‘initial margin.’
It’s important to note that you do not have to margin up to 50%. You can borrow less if you want to, like 10% or 20%. But remember that some brokerages require you to deposit more than 50% of the purchase price.
Obligations for loan possession
You are able to keep your loan for as long as you want. With that being said, you must fulfill your obligations, which are the following:
- When you sell stock in a margin account, the proceeds will go to your broker against the repayment of the loan. That is until it’s fully paid.
- There is a restriction that’s known as the ‘maintenance margin.’ This is the minimum account balance you have to maintain before you must deposit more funds or sell stock to pay your loan. When this happens, it’s a ‘margin call.’
Cost of borrowing
As you might expect, borrowing money is costly. Marginable securities within the account are collateral. Because of this, you will have to pay the interest on your loan. Interest charges are applicable to your account unless you decide to conduct payments. Your debt level increases over time as interest charges collect against you. As debt proceeds to increase, the interest charge also increases, and so on and so forth.
Consequently, “buying on margin” is primarily for short-term investments. The longer you hold onto an investment, the greater the return that needs to break even. If you hold an investment on margin for a long time, the odds of making a profit aren’t favorable.
Not every stock qualifies to be bought on margin. The Federal Reserve Board is the governing body that determines which stocks are marginable. Brokers do not permit customers to purchase penny stocks or over-the-counter Bulletin Board (OTCBB) securities.
Additionally, customers can’t purchase Initial Public Offerings (IPOs) on margin due to everyday risks that come from these types of stocks. Individual brokerages are also able to decide not to margin certain stocks. With that in mind, it is smart to check with them to see what restrictions may exist on your margin account.
‘Buying power’ is also commonly known as excess equity. It is the money an investor has available to purchase securities when considering the term in a trading context. Buying power equates to the total cash in the brokerage account in addition to the available margin.
Let’s use an example to explain this concept. You deposit $10,000 into your margin account. Since you put up 50% of the purchase price, this means you have $20,000 worth of buying power. Following this, assuming you purchase $5,000 worth of stock, you still have $15,000 in buying power remaining. You have plenty of cash to cover this transaction and you have yet to tap into your margin. You start borrowing the money only when you purchase securities that are worth more than $10,000.
This brings us to a very important point concerning the buying power of a margin account. It will change daily depending entirely on the price movement of the marginable securities within the account.
What comes from signing up
According to The Balance, when you sign up for a margin brokerage account, the following things will occur:
- All securities in your account are held as collateral for a margin loan, including stocks, bonds, etc.
- The margin maintenance requirement varies from broker to broker, stock to stock and portfolio to portfolio. The brokerage firm has the right to change this at any time so you might find yourself with a demand to immediately pay off your margin debt balance with no warning or face having your portfolio liquidated.
- If you fail to meet a margin call by depositing additional assets, your broker may sell off some or all of your investments until the required equity ratio is restored.
- It is possible to lose more money than you invest when using margin. You will be legally responsible for paying any outstanding debt you may have to your broker even if your portfolio is completely wiped out.
- The interest rate charged by your broker on margin balances is subject to immediate change.
The very concepts of ‘maintenance margin’ and ‘margin call’ are crucial when it comes to understanding margin accounts. These were referenced earlier on the topic of obligations pertaining to keeping loans, now we will go more into detail.
Let’s imagine that you open a margin account with $5,000 of your own money. Moreover, you have $5,000 from your brokerage firm as a margin loan. You proceed to purchase 200 shares of a marginable stock at a $50 price. Under Regulation T, you will borrow 50% of the purchase price.
“…a collection of provisions that govern investors’ cash accounts and the amount of credit that brokerage firms and dealers may extend to customers for the purchase of securities.”
For the sake of this scenario, let’s assume that the Maintenance Margin Requirement (MMR) is 30%. The chart below illustrates the changes in the margin account as the stock price wavers over time. As the current stock price dips below the purchase price, account equity deteriorates steadily. This will culminate into a margin call when the shares are trading $35.
So, what’s the exact stock price below the triggering of a margin call? This occurs whenever account equity equals out to the Maintenance Margin Requirement. In terms of mathematics, this translates into the stock price.
Account Value = (Margin Loan) / (1 – MMR)
Using our current example, the triggering of a margin call will occur when the account value falls below $7,142.86. In other words, the margin loan of $5,000 / (1 – 0.30), which equals out to a stock price of $35.71. When the price of the stock which was at $50 at the moment of purchase falls to $35, it triggers a $100 margin call. Therefore, you have one of three choices to remedy your margin deficiency of $100:
- Deposit $100 worth of cash into your margin account.
- Deposit marginable securities that are worth $142.86 into your margin account. This will bring your account value back up to $7,142.86.
- Liquidate stock worth of $333.33, with the proceeds reducing the margin loan. At the current market price of $35, this will work out to 9.52 shares, rounding off to 10 shares.
The value of shares set for liquidation are figured out through computation by using the following formula:
Liquidation Value = Account – (Account Equity / MMR)
In this particular case, liquidation value is this: $7,000 – ($2,000 / 0.30) = $333.33. When the stock price drops to $30, the margin deficiency increases to $800. Once again, you are given three choices, which are more or less the same as the previous choices:
- Deposit $800 worth of cash into your margin account.
- Deposit marginable securities that are worth $1,142.86 into your margin account. This will bring your account value back up to $7,142.86.
- Liquidate stock worth of $2,666.67, with the proceeds reducing the margin loan. At the current market price of $30, this will work out to 88.89 shares, rounding off to 89 shares.
If for whatever reason you’re not aware of or cannot meet the margin call, your broker can liquidate the stock. They will do this in the amounts shown without any additional notices to you.
Platforms that use it
Hypothetical situations and comprehensive explanations are nice, but by now you might want some actual examples. Here are five crypto exchanges that utilize margin trading in their platforms.
1 – BitMEX
This platform uses margin trading for cryptocurrencies. In doing so, it has built a great amount of respect in the crypto field in a short span of time. The team consists of developers with experience, economists, and high-frequency algorithm traders. This effectively helps makes it a potentially reliable product.
The process of registration on BitMEX is quite simple. All you need to start is your email, and you can also secure your funds using the 2-FA validation feature that BitMEX provides. The platform currently offers margin trading for up to six cryptocurrencies. These include Bitcoin (BTC), Bitcoin Cash (BCH), Cardano (ADA), Ethereum (ETH), Litecoin (LTC), and Ripple (XRP).
2 – Huobi Pro
This is an international cryptocurrency trading exchange that has a multi-language platform and provides exceptional support. The headquarters is in Singapore with offices in Hong Kong, Japan, Korea, and the U.S. To start using this service, you need to register with your email ID and submit your documents for KYC (Know Your Client). This is a process that usually takes a day or two to complete.
Afterward, you can begin to trade. In doing so, you are able to use the platform’s margin trade feature. Here, it shows an array of cryptocurrencies that are available for margin trading. You can leverage up to five times in BTC and margin trade various cryptocurrencies for BTC. These include ETH, LTC, BCH, XRP, ADA, Ethereum Classic (ETC), Zcash (ZEC), and DASH.
3 – Poloniex
Arguably one of the first exchanges to appear in the entire crypto world. Its base of operation is in the U.S. and is under the ownership of the peer-to-peer technology company, Circle. Registration for the Poloniex Exchnage entails enrolling with your email, so it is relatively easy to start using the platform. However, to increase your trading limits, you need to submit to KYC requirements. On the bright side, this typically involves approval in mere hours.
Aside from providing normal trading accounts for day traders, Poloniex also offers margin trading features for advanced users. On this platform, you are able to leverage up to 2.5 times in BTC and margin trade over 10 cryptocurrencies. These include ETH, BitShares (BTS), LTC, DASH, StarCoin (STR), Monero (XMR), XRP, and Dogecoin (DOGE).
4 – Kraken
This is one of the largest Bitcoin and altcoin exchanges existing in the U.S. Not only that, but it’s also the biggest exchange in terms of EUR (Euro) volume. People can register by using their email ID and can officially start following KYC verification. It will usually take about 7 days to get the validation done from Kraken. After this, you are able to deal with fiat currencies like USD, EUR, CAD GBP, and many others.
You can margin trade on Kraken and obtain the benefit of diverse leverage options. These are something the platform provides in different pairs. Cryptocurrencies that you can margin trade on Kraken come in 16 different pairs including:
- XBT/USD – Base Currency is Bitcoin – Quote Currency is US Dollar – Leverages 2,3,4,5
- XBT/EUR – Base Currency is Bitcoin – Quote Currency is Euro – Leverages 2,3,4,5
- USDT/USD – Base Currency is Tether – Quote Currency is US Dollar – Leverages 2
- ETC/USD – Base Currency is Ethereum Classic – Quote Currency is US Dollar – Leverages 2
- ETC/EUR – Base Currency is Ethereum Classic – Quote Currency is Euro – Leverages 2
- ETC/XBT – Base Currency is Ethereum Classic – Quote Currency is Bitcoin – Leverages 2,3
- ETH/USD – Base Currency is Ethereum – Quote Currency is US Dollar – Leverages 2,3,4,5
- ETH/EUR – Base Currency is Ethereum – Quote Currency is Euro – Leverages 2,3,4,5
- REP/EUR – Base Currency is Augur – Quote Currency is Euro – Leverages 2
5 – Whaleclub
This is another platform who’s base of operation is in Hong Kong. It permits margin trading of not just cryptocurrencies, but also commodities and forex (foreign exchange). In recent years, it’s become a recurring name in the crypto margin trading market. As it is, you are able to deal in five cryptocurrencies over the Whaleclub platform. These cryptocurrencies are BTC, ETH, DASH, LTC, and XMR.
This is the margin trading schedule for each of these cryptocurrencies and their supported pairs:
By partaking in margin trading, you are given access to a variety of potential advantages. They can be summed up in four categories: leveraging your gains, utilizing trading opportunities, diversifying your portfolio, and “carry” trades.
- Leveraging your gains
Purchasing shares on margin allows you to leverage your gains by enabling you to buy more shares. That is to say, more than what you get on a cash-only basis. The chart below shows how buying shares on margin can facilitate a return on investment that’s double the return without using margin.
- Utilizing trading opportunities
Trading shares on margin allows you to take advantage of any existing trading opportunities. This is without needing to raise cash by way of unloading your investments or other sources.
- Diversify your portfolio
A margin account can often be effective in diversifying or hedging your portfolios. If your focus is primarily on a few stocks or sectors, your account can add positions in other stocks or sectors. This will improve the general diversification. If your portfolio is already diverse and you want to hedge downside risk, you can short sell the broad market or a specific sector. There are also other hedging options. Short selling – among other options – is typically only done in margin accounts.
- “Carry” trades
A carry trade means borrowing at a lower interest rate and investing in an instrument that can produce higher returns. While currency carry trades are common in the currency market, a perceptive investor can use it in the stock market.
Just as there are an array of advantages, so too are there a variety of risks. The ones we’ll go over are amplified losses, the margin call, liquidation by force, interest charges and rate risks, and monitoring accounts/portfolios.
- Amplifying losses
The chart below shows the possibility of losing more than 100% of your investment in margin trading. A loss of $10,425 on $10,000 means that the trader is on the hook to the brokerage for an additional $425. If the stock plunges to zero after six months, the loss is $20,425. The return on investment is -204.25%. The trader has lost the full investment and also has to repay the brokerage the $10,000 margin loan, plus the $425 interest charge.
- Margin call
This one is pretty self-explanatory, as we have gone over it already. The end result is the investor needing to come up with cash or marginable stock at short notice.
- Forced liquidation
Failing to meet a margin call means that the brokerage can sell the margin securities without further notice. A plunging market can result in the investor’s position being sold at the worst possible time. Moreover, the investor can potentially be subject to a ‘whipsaw’, which is when “…the security’s price is moving in one direction but then quickly pivots to move in the opposite direction.”
- Interest charges and rate risk
The interest cost on margin debt adds up over time and erodes gains made on margin securities. Additionally, interest rates fluctuate during the time that an investor has margin debt. In this environment, the interest rates will increase and add to the Internet burden for investors in margin trading.
- Extra account/portfolio monitoring
Margin trading requires vigilance in monitoring margin accounts and portfolios. This ensures that margin remains above the level of requirement and can be stressful during market volatility.
Techniques for risk mitigation
With a plentiful amount of risks, one would obviously want to mitigate them as much as possible. Some of the more common strategies are the following:
- Avoid hilt leverage
You might be able to take on a large amount of margin debt. Moreover, you might have an unshakeable belief that your trading ideas will work. Regardless, you shouldn’t leverage yourself to the maximum amount. Leave some breathing room just in case your trades go against you.
- Use margin for short-term trading
Margin trading isn’t suitable for long-term strategies. Interest costs on margin debt add up substantially over time and create dents in your profits. It’s better to use your margin account for more opportunistic trading where you need some leverage.
- Use margin for a diverse portfolio
Using margin for a collection of stocks or a diverse exchange-traded fund (ETF) reduces the chance of triggering a margin call. If you have a large position in a stock, you’re susceptible to a margin call. This is because any number of events can result in a decline in the stock’s price. An earnings miss, a development in the company’s prospects, regulatory alterations, a drop in the market, and many others.
- Prepare to take losses
Get into the mindset of a trader and accept losses as an inevitable outcome of trading. This often means exiting your position, even if that means you’ll have to take a small loss. This is in lieu of hoping that the stock will turn around while simultaneously watching your losses go out of control.
Another mitigation technique is appropriately titled ‘risk management.’ It helps cut down losses and can assist in protecting a trader’s account from losing all of their money. It is a crucial prerequisite – one that many overlook – to successful active trading. If you managed to garner substantial profits, you could easily lose it all in a very bad trade without any proper risk management strategies.
When you use margin, it’s a good idea to develop a risk management plan. This basically means monitoring your investments and being up to date on market developments. For instance, you should be aware of release dates for important economic data that can potentially move the markets. Carry out stress tests to determine what your losses may be in unfortunate circumstances. Through this, you can formulate your strategy beforehand. Do you cut your losses or do you inject additional margin into the account?
Some think it’s smart to have a margin account at the same broker where you hold the rest of your investments. This is so that you can transfer funds promptly in the event of a margin call.
Some simple, yet essential, strategies you can employ to protect your trading profits include the following:
1 – Planning out your trades
Make sure that your broker is right for frequent trading. There are some brokers who cater to customers who trade infrequently. They typically charge high commissions and do not offer the right analytical tools for active traders.
The more unsuccessful traders usually enter a trade without having any idea of the points at which they will sell at a profit or a loss. Losses tend to provoke people to hold on and hope that they make their money back. Meanwhile, profits can entice traders to unwisely hold on for more gains.
2 – Take the ‘One-Percent Rule’ into consideration
This is a rule that “…suggests that you should never put more than 1% of your capital or your trading account into a single trade. So if you have $10,000 in your trading account, your position in any given instrument shouldn’t be more than $100.”
This strategy is very common for traders who have accounts of less than $100,000. There are some even go as high as 2%, assuming they can afford it. Many traders with accounts that have higher balances may end up going with a lower percentage. This is because as the size of your account increases, so too does the position increase. The best way to keep your losses under control is to keep the rule below 2%. Any more than this and you risk a substantial amount of your trading account.
3 – Stop-Loss and Take-Profit points
A ‘stop-loss point’ is the price at which a trader will sell a stock and take a loss on the trade. This frequently happens when a trade does not play out how the trader wanted it to. These points prevent the “it will come back” mindset and also limit any losses before they can escalate. Should a stock break below a key support level, traders will often sell as soon as possible.
A ‘take-profit point’ is the price at which a trader will sell a stock and take a profit on the trade instead of a loss. This is when the risks limit the additional upside. Should a stock price approach a key resistance level after an upward movement, traders may want to sell before a period of consolidation.
4 – Calculate the expected return
Setting stop-loss and take-profit points are essential in calculating the expected return. You can calculate this by using the following formula:
[(Probability of Gain) x (Take Profit % Gain)] + [(Probability of Loss) x (Stop-Loss % Loss)]
5 – Diversify and/or Hedge
If you put all of your money into one stock or instrument, you’re making yourself vulnerable to a big loss. It’s important to remember that you should diversify your investments. Not only does this aid in risk management, but it also opens you up to more opportunities.
As mentioned back at the beginning, margin trading is an intricate topic. There is so much to be said about it and hopefully, this guide was plenty informative.