Margin Strategies: Three Ways to Use Margin & Leverage
For traders and investors, margin strategies can come in handy when potential opportunities arise. Margin can increase buying power, enable access to advanced trading strategies, and even act as a line of credit.
In this video, we’ll explain margin, discuss its potential risks and rewards, and list the requirements to enable margin in your brokerage account. Essentially, margin is money borrowed from your broker to buy stocks or other securities.
According to the Federal Reserve’s Regulation T, investors can borrow up to 50% of the purchase price of a marginable security. For example, an investor with a $5,000 account could borrow an additional $5,000 to purchase up to $10,000 worth of stock.
The securities in your account act as collateral, and you pay interest on the money borrowed. Using margin, you can put up less than the full cost of a trade, enabling larger or more diversified trades.
This is called leverage.ť When combined with proper risk and money management, leverage can potentially lead to higher returns. Leverage, of course, is a double-edged sword. Because margin magnifies both profits and losses, losses can be accelerated.
This can lead to a margin call. If you do not take action or deposit more funds, your stock may be sold with or without prior notice. It’s even possible to lose more than the initial amount used to purchase the stock.
For example, this can happen when a stock bought on margin has a sudden, dramatic down move. To help avoid this, practice good money management. In other words, if you have $10,000 of available buying power, don’t overleverage your account by using it all at once set aside some of it in case markets move against you.
This can help reduce the likelihood of a margin call, and the remaining buying power can be used to manage a losing position. In addition to providing leverage, margin can enable the use of advanced stock, options, and futures strategies.
Some of these require additional account approvals and each carry their own risks, so not all clients will qualify. One strategy is short-selling. Short sellers seek to profit from a declining share price.
Instead of buying a stock to open a position, you borrow shares from your broker and sell them. Your broker then withholds cash in your account, reducing the available buying power. This buying power reduction is referred to as a margin requirement.
Once you buy back the shares, the margin requirement is released. Note that the risk of loss on a short sale is potentially unlimited, and your position may be closed out by your broker without regard to your profit or loss.
In addition to short selling, margin enables the use of advanced options strategies. While buying options does not require margin, selling uncovered options and trading spreads does. The margin requirements on naked options vary; however, when selling spreads, the total amount at risk is withheld from your buying power.
And much like trading stocks on margin, futures margin allows you to put up less than the full price of a trade. Specifically, a futures trader is required to put down a good-faith deposit with a broker called the initial margin requirement.
The requirement is typically 2%-12% of the contract’s total value. Keep in mind that futures trading is speculative, and is not suitable for all investors. And finally, margin can play a role beyond buying and selling securities specifically, as a line of credit.
Whether it’s for a large purchase or funds for an emergency, a margin loan can offer an alternative to traditional borrowing. Once you’ve been approved for margin, you can take out a loan at any time without additional forms or applications.
Like any loan, you’ll incur interest charges. However, because margin loans are collateralized by securities, your interest rate may be lower than conventional loans. And, the interest may be tax deductible, so be sure to check with a tax professional.
Also, you can repay the money when it’s convenient as long as the loan is in good status and you’ve met the maintenance requirements. To qualify for margin, you must deposit cash or eligible securities totaling at least $2,000 in equity and sign the margin agreement.
As long as the equity stays above $2,000, margin will be enabled in your account. Please note that margin is not available in all account types. Ultimately, it’s critical to understand the risks of margin along with its benefits.
Trading on margin can expose you to additional costs, increased risks, and potential losses in excess of the amount deposited. As always, carefully review your investment objectives, financial resources, and risk tolerance to determine whether margin is right for you.
However, when used properly, margin can become a powerful tool for traders and investors alike.