How to Trade on Margin...and is it Worth the Risk?

Meir Barak |

Margin_Trading.jpgWhat’s a Margin?

A margin is a loan that brokers provide to traders. As with every loan, margin bears interest. However, if a trader makes use of their margin during the course of the trading day, they are not liable to pay any interest.

When a client opens an account with a broker, the client can choose a margin account or a cash account. A margin account allows you to buy stocks at a multiple of four times your money: for example, if you deposited $30,000 in your account, you will be able to buy intraday (in one day’s trading) stocks valued at $120,000. In other words, the margin carries a 4:1 ratio. 

By contrast, if you want to hold stocks overnight, perhaps fearing that the stock price may change in the course of two days’ trading, you will need to be satisfied with a 2:1 margin. This sets your buying power at $60,000. If you use this doubled buying power between two trading days, you will be charged interest. Clearly, it is worthwhile to use the intraday margin during one trading day, as you will pay no interest. I support using margin beyond one day of trading, despite the interest charged, because the trading method that holds for several days is based on aggressive profit goals of several percent. This means the annual interest charged allows a higher expected profit. In short, margin allows you to work with higher sums than your regular cash balances allow.

The Potentially Dangerous Downside of Margins

Using margin also has its disadvantages. Let’s say you deposited $10,000 in your account and bought 1000 shares at $10 each, using your entire deposit without using any margin. A drop of 25% in a stock price from $10 to $7.5 will cause you a loss of $2500, or 25% of your money. On the other hand, if you use a 4:1 margin, buying 4000 shares for $40,000 followed by a drop of 25% in price will cause $10,000 worth of damage and wipe out your account! And what would have happened if you'd slept on Lehman Bros stocks after the Sub-Prime Crisis when they plummeted to $3 and the next day were worth mere cents? When you sleep on a margin of 2:1 and the stock price drops more than 50%, this is the stage in which you are losing not only your own money but that of the broker too. The broker’s job, of course, is to prevent risks of this kind. This is why brokers maintain a risk department whose job it is to keep tabs on your account and warn of potentially hazardous situations. In actuality, it rarely happens that a client loses more than the amount in his or her account.

So is margin risky? To experienced professionals, not at all. They will never endanger more than a pre-defined sum of money. This sum, which they are willing to risk, will have nothing to do with margin. As we will learn further on, they use stop orders as protection, and plan in advance the maximum dollar loss they are willing to absorb. They never absorb losses of tens of percent, and never endanger their trading account. If you remain disciplined and operate according to the rules, you will learn as we progress, and margin will become a gift at your service when used wisely. By contrast, if you are not sufficiently self-disciplined and have a tendency to gamble…beware!

What’s the Upside to Brokers?

Brokers are at risk and do not share in the profits you can make from margin: so why would they bother to provide you with margin? There are two main reasons:

  1. For the broker, interest is profit. When you buy on margin beyond the trading day on which you purchased the stock, you pay interest, from which the brokers make a profit
  2. The greater the sum of money accessible to you, the more probable it is that you will execute more transactions with greater volume. 

In short, margin benefits both sides: the trader can put in just one quarter of the amount needed and enhance his or her potential on each trade by double or quadruple, while the brokers benefit from greater volume of activity which creates more commissions.

The Long and Short of Trading with Margins

In light of the dangers inherent to using margin, day trading rules prevent brokers supervised by American regulations to provide margin greater than a 4:1 ratio on any single trading day and a 2:1 ratio for more than one day. In fact, the condition for being allowed to use margin is that you are required to deposit a minimum of $25,000 in your account. In any case, even if you do find a way to reach higher margin, I would advise that a new trader make do with the 4:1 ratio. A reasonable margin prevents mishaps of this kind. In short, be satisfied with a little less, and you very well may save a great deal.

 

To learn more about the stock market and to begin your own journey toward financial independence, visit Meir Barak's site Tradenet and check out his book "The Market Whisperer."  

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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