In this article, we’ll talk about trading with margin, or margin investing, and how to avoid margin calls.
What is margin? I’ll give you a very specific example. Then we’ll talk about the advantages of margin trading, the dangers, and these so-called maintenance requirements.
What is a margin call? It’s bad when it happens, so we will cover how to respond when it does. We’ll also talk about portfolio margin.
What Is Buying On Margin?
Margin is basically borrowing money from your broker, on your brokerage account. You can think of it as a loan. Margin trading, as you’ll see in an example here in just a moment, allows you to buy more stocks than you’d be able to do normally with borrowed funds.
To trade on margin you need a margin account. This is different from a regular cash account in which you trade using the money that you have in your account. You are also borrowing money from your broker.
By law, your broker is required to obtain your consent to open a margin account, meaning the broker cannot simply turn your account into a margin account. It doesn’t work like this.
A margin account may be part of your standard account opening agreement where the broker asks you,“What account do you want to open? Do you want to open a margin account and we will give you more money? Or do you want to have a cash account?”
How It Works
By law, an initial investment of at least $2,000 to your account balance is required for a margin account, but some brokers require more. This deposit that you have initially, it’s also known asthe minimum margin, and once the account is open and operational, you can borrow up to 50 percent of the purchase price of the stock.
For example, let’s just say that you put $10,000 in cash into a margin account. This means you can borrow another $10,000 from your broker. You don’t have to do this as it’s basically like a line of credit, so you can borrow less, or you can borrow none at all.
The important thing is you can keep your loan on the margin as long as you want, provided you fulfill your obligations, such as paying interest on time.
When you sell the stock in a margin account it’s pretty much like selling your house. At first, the proceeds go to your broker against the repayment of the loan. Much like a mortgage, when you sell your house the bank is being paid first.
Now there’s a restriction called themaintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock. And when that happens, it’s a margin call, and we’ll talk about this in a moment.
An Example On Using Margin
Let’s say you’re putting $10,000 cash in your margin account. Your broker will loan you another $10,000. That is UP TO $10,000. This is borrowed money but again, you don’t have to. This means that you have a buying power of $20,000.
Let’s just do an extreme and let’s say with this buying power of $20,000, you are buying 100 shares of a stock that is worth $200. So this means that now you’re using every single cent of your buying power in the account, but there’s a reason why I’m using this extreme here.
Now, when you do this, $10,000 of this $20,000 is your cash, and $10,000 is the borrowed money on your brokerage account. On the $10,000 you borrowed from your broker, you’ll pay interest. But why would you consider doing this and trade on margin?
Advantages of Margin Trading
For example, let’s just say the stock rises by 25% from $200 to $250. What does this mean? Now, your portfolio value is 100 shares that you have, times $250. This means it is worth $25,000 in total.
Now keep in mind, this $25,000 in your portfolio means you have a profit. It went from $20,000 to $25,000. This is a profit of $5,000.
$10,000 was your cash to start off with. Based on this $10,000, that is a 50% increase because you made $5,000 based on your original $10,000.
If you think about it, the stock only rose 25%, but you made twice as much money because you leveraged your account using margin.
Dangers of Trading On Margin
What are the dangers of trading on margin? Let’s look at this the other way around. If that same stock dropped by 25%, and it drops from $200 where you bought it to $150, your portfolio value is now 100 times $150. This means $15,000 is what your portfolio is now worth.
How much are you losing? You had $20,000, but now you only have $15,000, so this means that you have a loss of $5,000. Based on your initial $10,000, this is a loss of 50% even though the stock only dropped 25%.
As you can see, leverage and margin is a double-edged sword. You can make money twice as fast but you can also lose money twice as fast. You must know what you are doing before using margin and have realistic risk tolerance. There definitely is risk involved.
What Are “Maintenance Requirements?”
First, you need to understand we have something that is called theinitial margin, and the initial margin is 50%. This means that 50% of your total value of the portfolio can be margin.
As I said before, if you have $20,000 in buying power, $10,000 of this can be margin which is the loan from the broker. Now let’s talk about themaintenance margin.
The maintenance margin varies from broker to broker, but it’s typically around 25% or even 35%. Please check with your broker. What impact does this have? Let me give you another example here.
Maintenance Margin Example
As with the previous examples, we have $10,000 in cash and we have the $10,000 loan from your broker, which is the margin. This means we have $20,000. Now let’s say that the stock that we used in the previous example drops by 20% going from $200 to $160.
What is our portfolio value? Our portfolio value is now 100 stocks that we had, times $160, which is $16,000.
Now the question is, how are we doing here with themaintenance marginrequirements? Well, we take the $16,000, times the 0.25 (25%), which means that the maintenance margin requirement is $4,000.
Stick with me because this is important. This is what very few traders understand. Let’s take a look at this. We have a $16,000 portfolio value, and we have a $10,000 loan that we received from our broker. Now we need to subtract the $4,000, which is themaintenance margin.
If we do this, we have $2,000 in excess so we are good here. Now let’s say that the stock keeps dropping to $140.
This is what very few traders who are trading on margin understand about howmaintenance marginworks. Now your portfolio is worth $14,000 dollars, right? You have 100 shares times $140.
We are calculating how much is themaintenance marginthat we need, and this value could be 25%, or your broker might actually maybe require 30% or 35%, so you need to understand how much it is. But if you are taking this times 25%, we are ending up at $3,500.
This here is, again, themaintenance marginrequirement. Let’s see if we are still golden or if we are getting a margin call here.
So now the portfolio is worth $14,000, we have borrowed $10,000 from the broker, so we have to pay this back. This is our loan, the margin. Minus $3,500 and we are still good. We have $500 in excess. No margin call yet, but here it comes.
If the stock drops to $120 your portfolio is worth $12,000. We’re taking the 0.25, $3,000, and this is now themaintenance marginrequirement.
Now we have $12,000 in your portfolio, minus the $10,000 loan from your broker that you took out in the very beginning when you bought the stock for $200. Now minus the $3,000maintenance requirement,and now it is $1,000 negative.
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So what happens when it is $1,000 negative?
What Is A Margin Call?
Because you still have to pay back the whole $10,000 loan, this is when you are getting amargin call.
What is a margin call? Technically, it is a demand from your broker to add money to your account or to close out your positions so that you can pay back the money that you owe the broker to bring your account back to the required level.
If you get amargin call, it’s typically an email that the broker sends you. Make sure that you’re not ignoring this.
How Do You Respond To A Margin Call?
How do you respond to a margin call? You have two possibilities.
Number one, you could sell your position.
What would happen if you sell your position? Your account value is $12,000 right now, and the stock is trading at $120. You have to give the broker back $10,000, this means that right now you have $2,000 left in cash in the account.
Since you are trading on margin based on your initial $10,000, this means that now you have an 80% loss, even though the stock dropped only 40%.
The other possibility is that you send the broker the funds. The question is, how much time do you have to send additional funds? It really depends on your broker.
Example Number One
With the brokerage account tastyworks, monthly maintenance calls are typically due three business days after the call is issued, but tastyworks reserves the right to require maintenance calls to be met sooner.
So pay close attention to your email because they might tell you that you only have a day or two.
Example Number Two
If you’re on the brokerage account Interactive Brokers, you need to understand that when the balance in the margin account falls below themaintenance requirement, the broker can issue a margin call but…
There are no margin calls at Interactive Brokers. What does this mean? How much time do you have? This would be anywhere between 24 to 72 hours, but again, check with your broker.
Ignoring A Margin Call
So what happens if you ignore the margin call, or if you’re with Interactive Brokers? If you do not meet themargin call, your brokerage firm can close out any open positions in order to bring the account back up to the minimum value.
And your brokerage firm can do this without your approval, and they can choose which positions to liquidate. Now, as you can imagine, this is the worst-case scenario because they just choose any of your positions.
So in our example that I’m using, we only have one position, so it’s easy for the broker to choose. But if you have multiple positions, you have to be super careful because now you’ve lost control.
Long story short, what does this mean? It means never, ever ignoremargin calls. You have to do something. Either sell your positions or send the broker more money. I
f you send the money don’t do ACH or send a check, because the broker doesn’t care when you initiated this. They only care when the money is back into the account.
What Is Portfolio Margin?
Understanding margin is important. Now, let’s very briefly talk aboutportfolio margin. Basically,portfolio marginis margin for bigger accounts.
Every broker uses a different measurement. Some brokers allow you to apply for portfolio margin when you have $125,000, maybe as much as $175,000, or maybe even $200,000. It really depends on your broker.
So why is it more here? It usually gives you a much larger margin. If we had $100,000, a margin account would turn into $200,000. This is with the so-called regular margin. This regular margin is also called Reg T Margin.
Now if you haveportfolio margin, $100,000 could turn into up to $610,000. So as you can see, you get much more leverage. And as you already know, leverage is a double-edged sword.
But why do I say up to $610,000? Well, there’s a quite complicated formula, I got this here from TD Ameritrade.
You see, with portfolio margins, stocks and options are tested by hypothetically moving the price of the underlying between plus and minus 15%.
The price ranges are then divided into 10 equidistant points, and the loss or gain on the position is calculated at each of the ten points. There’s a bit more to it, but you get the idea.
What does it mean? It’s complicated, but what it basically means is its subject to change all the time based on volatility. This is why portfolio margin is tricky, and also dangerous. You need to know what you are doing withportfolio margin.
Summary
Now you know what margin is, and you know the advantages of margin trading. You also know the dangers.
If right now you still don’t understand thesemaintenance requirements, please read this article again.
When you get amargin call, do not ignore it. It’s the worst thing that you can do. If you’re with Interactive Brokers, they’re not issuing any margin calls, they immediately liquidate.
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You can grab a copy of The PowerX StrategyHERE, and a copy of The Wheel StrategyHERE. These books are free, all we ask is that you cover shipping and handling ($4.99).
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