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Now You See It, Now You Don't: A Primer for Trading on Margin

January 1, 2012
trading on margin
Fredrik Broden

A tweet you'll likely spot on Twitter after a sharp rally: “Anyone who bought XYZ on Monday earned 25% if he bought on margin.”

A tweet you'll likely never spot on Twitter two days later: “Broker closed me out on that XYZ I bought on margin on Monday ahead of the selloff.”

And that's the deal when you trade on margin. It can add fuel to your returns when you get it right. But it can also wipe out your account in a blink when you get it wrong.

So, what's margin? Here's the long answer straight from the TD Ameritrade handbook:

“A margin account permits investors to borrow funds from their brokerage firm to purchase marginable securities on credit and to borrow against marginable securities already in the account. The terms of a margin loan require the qualifying securities or cash that you have in your account be used as collateral to secure the loan. Interest is charged on the borrowed funds.”

Here's the short answer: It allows you to borrow money from your broker to buy more marginable securities than you can afford.

Margin can increase your effective returns. It can also bankrupt you. And frankly, we tend to obsess over the latter, and for good reason. There can be benefits to trading on margin when used with care and discipline. It may allow you to take advantage of investment opportunities you would otherwise have to avoid simply because you were “priced out.”

Before you get started, make sure to understand how it all works, lest you get “that call” and have to sell securities, deposit more money, or worse, be forcibly sold out by your brokerage firm before you're able to put up more money (i.e. just when your investment thesis begins to play out).

Margin Types

Also known as “Reg T,” this type of margin typically allows you to buy a marginable stock with 50 % of the money the security would cost in full. Suppose you're loving yourself some XYZ stock trading at $20. You would like to buy 1,000 shares, or $20,000 worth. You only have $10,000 you can spare to invest, however. No problem. You can buy the stock on margin. You use the $10,000 you have and borrow the other $10,000--a loan on which you pay interest.

If XYZ dips at all, you could be in trouble. Let's say it goes down $1 to $19. The value of your holding is now $19,000 (1,000 shares of a $19 stock). You've lost $1,000, so your equity in the position is only $9,000.

TD Ameritrade has various maintenance requirements for stocks, the most common being 30 %. So while you needed $10,000 to initiate the purchase, you “only” need to maintain $6,000 in equity (30 % of $20,000) to avoid a margin call.

Great, you have some breathing room. This can play out a couple of different ways:

On the good side, suppose XYZ lifts to $25. You now own $25,000 worth. You borrowed $10,000, so your equity stake is $15,000. Since you only actually put up $10,000, the $5,000 you earned represents a 50 % return. Since you've purchased shares on margin, when the stock rose 25 %, you made 50 %. Sweet. Cha-Ching. BooYa. Sign me up.

On the bad side, XYZ drops to $15. You lost $5,000. You started with $10,000 in the account, so now you have $5,000 left, and you still owe $10,000 to your broker. You dropped 50 % on a 25 % drop in XYZ. What's more, you now have some maintenance issues. Your XYZ holding has a value of $15,000. In order to maintain that position, you need 30 % equity, or $4,500. You only have $5,000 equity left in the account, so that leaves a mere $500 of leeway. Not so sweet.

If XYZ goes any lower, you will get a margin call. At this point, you can:

1 —Put up more money and maintain the position (i.e. deposit funds or marginable securities into your account).

2—Sell other securities in your account to raise cash.

3—Close out of the position.

Depending on the situation, you may never get the choice, and the position can be closed out by your brokerage firm without your consent. And none of these options factor in ancillary expenses. You owe interest on the money you borrow, same as if you borrowed it anywhere. There are also trading commissions and regulatory fees, so keep on top of it all.

There's your basics. But wait—there's more. Other types of trading activities and other stocks have different margin rules that are not always the cut-and-dry 30 %. And maintenance requirements can also be raised at any time.

If you make four or more round-trip day trades within any rolling 5-business day period, and that represents at least 6 % of your total trading activity during the same period, you are now considered a Pattern Day Trader (PTD). You can open a regular margin account with as little as $2,000, but Pattern Day Traders need a minimum equity balance of $25,000 in order to day trade. What does that mean for you? Specifically, four times your excess equity. In other words, if you have $25,000 in your account above and beyond any money needed to hold securities, you have access to $100,000 of day-trading buying power. But keep in mind, if your equity drops below $25,000 minimum for PTD, you may be subject to a minimum day-trading equity call.

Margin requirements for defined-risk options strategies, such as long puts and calls, verticals, and iron condors are pretty straightforward. It works like a cash account inside your “margin” account, meaning you simply need to put the cash up for the cost of long trades, or in the case of short strategies, such as short verticals or iron condors, you'll need to put up the amount at risk. Short verticals, for example, would require the difference between the strikes less the premium received on the sell side of the vertical. Just remember that if/when you exercise such strategies, you will need to follow the margin rules on the stock or underlying.

Selling “naked,” though? As per TD Ameritrade, “The writing of uncovered puts and calls requires an initial deposit and maintenance of the greatest of the following three formulas:

A—20 % of the underlying stock less the out-of-the-money amount (if any), plus 100 % of the current market value of the option(s).

B—For calls, 10 % of the market value of the underlying stock plus the premium value. For puts, 10% of the exercise value of the underlying stock plus the premium value.

C—$50 per contract plus 100 % of the premium.”

Got that? As an example, let's say you want to sell 10 uncovered puts on XYZ, which is trading at $42. The strike price is $40, and the puts are trading at $3.

With formula a), you would need 20 % of $40, times 1000 shares, or $8,000, plus the market value of the options ($3,000), or $11,000.

With formula b), you would need 10 % of $40 (the exercise value) plus $3,000 (the value of the puts), or $7000

With formula c), you would need $500 for the 10 contracts, plus the $3000 of premium, or $3,500.

So, in this case, the big winner is formula a), and you would need to put up $11,000.

Keeping your head is about not over-leveraging. Margin is like anything. Used as a tool to benefit your trading strategy, it can potentially complement returns, particularly in underperforming markets. But abuse it, and that shiny new car you rolled the dice on just became a Hot Wheel.

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