What is Trading on Margin

Trading on margin is the ability to buy or sell more of a security than you would normally be able to with your account equity.  It is basically a loan from the brokerage provided as a service to clients.  By law you cannot have more margin value loaned to you than you have in equity.  Put another way, you can borrow up to 50% of the value of your purchase.  You are also free to borrow less if you wish.  Some brokers will require a higher percentage of account equity of the total margin purchase.

This applies to retail accounts, and accounts must be specifically given privileges as margin eligible accounts.  A broker will require an affidavit from the account owner stating that they understand all risks associated with trading on margin, and are in a strong enough financial position to assume those risks.  Margin accounts require a minimum deposit of $2,000, and some brokers will require a higher deposit.

Traders use margin in hopes of magnifying their gains.  If they are buying a position that is twice as big as the equity in their account, the hope is that they will make twice as much money from it.  This is sometimes the case, but unfortunately there are no guarantees.

Buying on margin is risky by nature.  When you have twice as much equity invested in the position than equity in your account, every price increase or decrease will have double the effect on your account equity.  This is very good if the position goes in your favor, and will at least double the damage if the position moves against you.  A trader should only use margin if they fully appreciate the risks and rewards.

Margin is also not free.  It can be thought of as a loan from the brokerage, and like all loans there is an interest rate attached.  The interest rate will vary amongst brokerages but will often be indexed to an established rate, for example the rate may be libor+ standard markup, or the rate could just be a flat rate.  Either way every day you are using margin, you are obligated to pay interest.  The interest is deducted from your account, and it usually behooves the trader to only hold positions on margin for short time periods.

If a trader is holding a security on margin, and the value of the position declines substantially, a trader may be subject to a margin call.  A margin call is a call made by the broker to add more funds to an account when the equity declines to a certain percentage of the total position value.  This happens to help assure the brokerage that they will not lose their own money on the position.  Different brokerages may have different standards for when a margin call is placed, but if funds are not added in time the brokerage will liquidate the position to a point where the account equity is an acceptable percentage of the position value.

Trading on margin can be beneficial for day traders as long as they have controlled risk parameters, but essential to understand the full consequences of using it.

Daniel Major

B.S. Degree in Economics and Finance. Professional day trader. Live and work in Manhattan, NY, NY.

Page Updated: February 14, 2013

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