Trading on Margin 101
What exactly is margin? Is it risky? Should you trade with a margin account?
We’re going to dive into the details of what exactly is margin in day trading, the pros and cons of using a marginal account and of course, how to use margin to your advantage to grow your accounts exponentially.
Before we proceed, here’s a brief explanation of what it means to day-trade with a margin account vs a cash account.
Margin vs Cash Account:
Let’s assume we’re using a regular cash account which is the most conventional investment account to trade, and let’s say we have a $5,000 small cash account.
In this example, if Tesla(TSLA) is at $340 right now, I could only buy 14 shares of Tesla with that $5K. If I sell my shares at $360, I make $20 a share. On 14 shares, that's $280 with a cash $5,000 account. Not bad right?
Now, what if I'm trading the same $5,000 in a margin account? Margin trading allows you to borrow funds from your broker, therefore increasing your buying power in order to purchase more shares than if you were just using your own $5,000 in cash. Instead of just $5,000 buying power, I now could use up to $20,000 of buying power when using margin.
Let’s look at day trading with margin in this case. If I buy Tesla stock with the intention of buying for the dip here and selling it for a quick bounce, I could buy double the amount of shares of TSLA since my broker allows me 4:1 leverage when trading on a margin account.
Therefore, if I sell my Tesla for a bounce of 20 points, then I made $20/share. On 30 shares, that's a $600 return, only using my own $5K of capital.
Benefits of A Margin Account:
1. Using Leverage
This is the biggest pro of trading on a margin account. By using leverage properly, margin accounts let you amplify your potential returns as well as your losses, which is very important.
When you use margin, you are borrowing money from your broker to finance part of your trade. Most brokers will give you a 3:1, 4:1 or sometimes 6:1 margin of buying power when day trading intraday, so with the same $5,000 capital, I could get up to $15K, $20K or even 30K worth of buying power.
However, when holding positions overnight, the buying power drops to 2:1 meaning a maximum $10K of buying power.
2. Trade settlement periods
If you’re using a cash account to day trade, the capital you use in these positions will take 2 days before it comes back to your account. In our example earlier on the TSLA trade, if I bought 14 shares of TSLA and made that $280 profit, I would have to wait 2 days for that $5,040 cash to return to me with $4,760 being my original capital and $280 being the profit from the trade.
In other words, I only have $240 left in my cash account for the next two days. I essentially can't trade until that cash settles. It's very important to wait 2 days. Trust me; you don't want to experience violations and risk your broker locking your account for 90 days. It's the same as violating the PDT rule.
With a margin trading account, you do not have to wait for the cash to settle before reusing that capital again. This, my friends, is extremely beneficial especially if you want to become a full time day trader. There's different opportunities in the market every single day. I don't know about you, but I want to have to wait 2 days to trade again.
In our example, once I'm closed out of my TSLA long trade, the profits of $600 will not come in until the next trading day. I could reuse my original $5,000 capital and then 20,000 buying power in the same day.
3. Popular Short Selling
I kept the best and biggest pro for the last point and it is none other than the popular short-selling.
Even if you don't need the extra leverage in buying power, or you don't care about the cash settlement period because you’re trading part time anyways, having the ability to short sell opens so many opportunities to profit in the stock market regardless of whether the market is going to the moon or crashing to the ground.
A margin account allows you to short sell and profit from the falling stock prices. With short-selling, you can borrow shares of stock from your brokerage firm, sell the shares and buy them back at a lower price. Your profit is the difference between the proceeds of the original sale minus the amount required to buy back the shares.
You cannot short with a cash account.
Despite all these benefits, day trading with a margin account is not for the faint-hearted. That's why it's important to understand what margin trading really is, and what the pros and cons are, so you can decide for yourself. It’s most important that you’ve taken risk management seriously.
Why am I saying this? Margin accounts come with higher risks than cash accounts. You are not only trading with your funds, you are also trading with your broker’s funds. If you start gambling with your entire buying power, chasing the high of the day breaks and following chat room alerts, not only do you risk your original $5K capital, you could also owe your broker a lot of money.
Margin Maintenance
When using margin to day trade, you must be aware of the margin maintenance for your account. Margin maintenance is the amount of capital you need in order to keep your trading position open.
For example, if a trader borrowed the broker's money to buy 30 shares of TSLA at $340, he or she would borrow $5,200, plus $5,000 of his or her own capital. The total value of the position is $10,200, and the margin maintenance would be 50%, in this case .
Since they own $5,000 worth of capital, if their broker has a minimum margin maintenance of 30%, this stock position is perfectly fine because his maintenance of 50% is above the margin maintenance of 30%.
God forbid if that same day, Elon Musk is bored out of his mind, and he decides to tweet.
In that case, let’s hypothesize TSLA stock drops to $240. That means the value of this trader's long position is now only $7,200. Remember, though, the trader borrowed $5,200 earlier from my broker, since he used margin to purchase this TSLA stock position.
This is where the trader would be treading in dangerous waters because if you take the valuation of the position, which is now $7,200 minus the amount he loaned from his broker ($5,200), the amount that actually belongs to the trader is now down to $2,000, which is very different from his original $5,000 capital. $2,000 remaining is only 27.77% of margin maintenance.
Remember, since our margin maintenance from earlier was 30%, and the current valuation of his long position on TSLA is now gone from $10,200 to $7,200, the trader must keep at least $2,160 in the trading account to keep this position open.
Margin Call
Since the stock position has now fallen under a 30% margin maintenance, this is when you’ll get an important phone call. No, it's not your significant other calling you to tell you how much they miss you or love you. It’s even worse.
This is what we call a margin call. A margin call is not an actual phone call nowadays. Maybe it used to be, but even the brokers are too lazy to pick up the phone and dial now.
Usually, it's an email or text alert sent to your phone from your broker demanding that you fund additional capital so your position keeps above 30% maintenance.
To respond to the margin call, the trader in our example could either fund at least an additional $160 to his account to stay above 30% margin maintenance, or they could sell part of the stock position for a loss. However, the equity released would reduce the amount he or she is borrowing from the broker.
A third option would be if the trader does not act fast to respond to the margin call, the broker may liquidate the entire position without any further notifications. Liquidation ensures that the broker will get their original $5,200 loan back. They gotta protect their ass right? They want to make sure their capital is safe and some of yours too, maybe.
Therefore, if the TSLA long position gets liquidated at $240, that means the trader would take a loss of $100/share. On 30 shares, that's a realized $3,000 loss. Basically, this is a 60% cut of that original $5,000 account.
Like I mentioned earlier, while using a margin account gives you 4:1 or greater leverage buying power, it also increases your risk. That's why I have the following tips for you if you decide to use a margin trading account.
Risk Management
1. Do not over leverage
Do not use your full buying power. If I have $50K in my account, that means I have up to $200K worth of buying power. I never use all of it. Just because you could, doesn’t mean you should.
If you’re new to trading and your capital in the margin account is only $5,000, only trade with that $5,000. For that example, you should only buy up to 14 shares of TSLA. You could keep a margin account so you get the ability to short sell and also have the funds settle within the same day.
2. Follow your stops
The trader in our example earlier is basically a “Mike Bagholder.” He didn't follow his stop. A proper trading plan should include entry, profit target and most importantly, a stop. That way, you can prevent one losing position from blowing up the entire account like we talked about.
Getting back to the question, “Should I day trade with a margin account?”
Margin accounts are extremely beneficial for professional traders who use them to maximize profits both on the long side and short side. When used correctly, you can fully maximize your buying power and take advantage of the market volatility.
When used incorrectly, or if the trader disregards risk management, you can lose their entire investment due to a margin call.
Again, your account type is just a tool of business in day trading. Whether it’s margin or cash will not determine your success or failure in trading. There's a lot of misconceptions online about margin, so it has a bad reputation because people say it's gambling or that it’ll be the reason you blow up.
Let me reassure you. Margin, by itself, is not the reason traders fail or blow up. It’s the trader’s own lack of risk management, lack of discipline or following chat room alerts at the HOD breakouts that does the damage.
Truth be told, a reckless trader can blow up both margin and cash accounts, so blowups are not limited to margin my friends.
Like Uncle Ben said in Spiderman, “With great buying power, comes the even greater responsibility of risk management.”
