As traders and investors, each of us eventually stumble across the topic of margin trading. It’s a service offered by popular commission free brokers, such as: TradeZero.
You’ve likely heard how margin trading could multiply your profits or you’ve seen social media posts boasting massive gains made by margin trading. Although it is certainly possible to use margin trading to your advantage in the market, it is imperative to fully understand how it works as well as the inherent risks that come with it.
Margin Trading – What is it?
Margin Trading, or using leverage, allows a trader or investor to borrow funds from their broker to boost or leverage up their position size when they do not have the cash available in their account to take such a position size. Basically, a trader using leverage is taking out a loan with their broker using their account as collateral, in order to increase their buying power. As one could imagine, this gives traders the potential to amplify their gains but at the same time it also creates the possibility of amplifying potential losses. It is recommended that an individual opens a margin trading account with extreme care and to not fully leverage margin without first proving consistent profitability in the market as well as tight control over their risk management.
Margin Trading Requirements
Not anyone can decide today that they would like to start margin trading as it does come with some requirements that must first be met. The United States Securities and Exchange Commission, or SEC, states that residents of the United States: “Before trading on margin, FINRA, for example, requires you to deposit with your brokerage firm a minimum of $2,000 or 100 percent of the purchase price of the margin securities, whichever is less. This is known as the ‘minimum margin.”
This $2,000 minimum equity requirement changes when an individual is flagged as a Pattern Day Trader, or PDT. According to the SEC’s Inverstor.gov: “FINRA rules define a pattern day trader as any customer who executes four or more “day trades” within five business days.” The minimum equity requirement for a PDT is relatively larger. The SEC states: “The minimum equity requirement for a customer who is designated as a pattern day trader is $25,000. This $25,000 requirement must be deposited into the customer’s account prior to any day trading activities and must always be maintained.” If a margin account falls below the minimum equity requirement the account owner must deposit more funds prior to making any more day trades.
If you’re a resident of Canada or another country outside of the United States, you may be subject to different margin requirements. Margin requirements with some brokers require an account be funded with as little as $500.
Visit TradeZero’s FAQ section to learn more about the margin requirements based on where you live.
How does a margin trade work?
To get an idea of how margin trading works let’s look at an example provided by the SEC: “Let's say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment (i.e., your $25 gain is 50% of your initial investment of $50). But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you'll earn a 100 percent return on the money you invested (i.e., your $25 gain is 100% of your initial investment of $25).”
Benefits of margin trading
Margin trading enables traders to take position sizes larger than they have the available cash to allow. When used properly along with your trading process and risk management, using this leverage could amplify your potential gains helping you to grow your account much faster. We saw this in the example provided previously as the trader saw a 100% return using leverage as opposed to the 50% return that he or she would have saw without the leverage. It’s also important to note that day traders actually require a margin account to participate in the market as short sellers. If you’ve ever wanted to try your hand at shorting stocks, opening a margin account would allow you to do so.
Risks of margin trading
Trading a margin account does come with inherent risks that anybody interested in opening an account needs to fully understand. For starters, traders can lose more cash on a trade than the total initial investment amount. This isn’t going to be a situation where one can only lose what they’ve put in, and traders must be willing to accept that risk before putting on the trade. Just as trading can amplify your winning trades, it will do the same to your losing trades.
A broker can hit a trader who has an open, leveraged position with what is called a Margin Call at any time. This is where the price of stock purchased with leverage falls reducing the value of held securities and the trader is required to provide more cash to his or her broker. Furthermore, brokers have the right to liquidate a trader’s position with no obligation of notice beforehand to pay off the margin loan.
Margin loans, like all loans, charge the borrower interest. The interest rates on these margin loans vary from broker to broker and sometimes vary substantially. The interest charges must be factored into a trader’s potential returns because the charges do chip away at total profit of winning trades.
To see all fees associated with using TradeZero as your broker read through their FAQ section here.
Given the basics of what margin trading is and how it works, traders must decide for themselves whether they feel trading with leverage would be beneficial to their account growth. Keep in mind that margin trading typically does not work out profitably for traders who are new to the markets. Trading with leverage should be left out of an individual’s trade plan until he or she has proven consistent profitability, tight risk management, good discipline and has an account which meets the minimum requirements.
DISCLAIMER
This content (“Content”) is produced by James J. Ciccolelli. The Content represents only the views and opinions of James J. Ciccolelli. Mr. Ciccolelli’s trading experiences and accomplishments are unique, and your trading results may vary substantially. TradeZero does not endorse the Content and makes no representations or warranties with respect to the accuracy of the Content or information available through any linked third party sites. The Content has been made available for informational and educational purposes only and should not be considered trading or investment advice or a recommendation as to any security. Trading securities can involve high risk and potential loss of funds. Mr. Ciccolelli’s is compensated by TradeZero for producing the Content and may also receive compensation for customers he introduces to TradeZero.
TradeZero provides self-directed brokerage accounts to customers through its operating affiliates: TradeZero America, Inc., a registered broker-dealer and a member of FINRA and SIPC; TradeZero Inc., a dealer registered with the Securities Commission of the Bahamas; and TradeZero Canada Securities ULC, an IIROC member firm and member of CIPF.
Sources:
- TradeZero |Home page| (July 8th, 2022)
- gov | Investor Bulletin: Understanding Margin Accounts (July 8th, 2022)
- gov | Margin Rules for Day Trading (July 8th, 2022)
- Pattern Day Trader | Investor.gov (July 8th, 2022)
- TradeZero | FAQs (July 8, 2022)