The Pros and Cons of Margin Trading

How much leverage do you think you can handle?

When you first start trading or investing, this is a theoretical question that fascinates the imagination. Leverage fuels some incredible money-making opportunities. But it can also be the most disastrous thing that could ever happen to a trader.

Let’s explore how margin trading is defined in different sectors of the trading industry along with the risks, rewards, and reality. 

What is margin trading?

Margin means different things in different marketplaces. Margin is the leverage that a brokerage firm allows you to have when you trade.

In the forex and the commodity futures arena all assets trade on relatively small margins and all that is required to create a position is a good faith deposit, dictated and regulated by the exchanges. This is also known as the initial margin requirement. For example, in forex it is not uncommon that you can control $100,000 worth of a currency with a small deposit of $3,000.  This is considered highly leveraged trading. When you divide the value of the asset by the value of the initial margin requirement it will give you the exact amount of leverage.

In this case it is 33.33 to 1.

A forex broker is not loaning you the additional amount to create the position. They are simply requiring that your account maintain a certain balance to remain in good standing and keep the entire position open. 

In this example, a forex broker will often say that your account will need to maintain a $2,000 balance to be able to keep the entire position open. 

Should your balance ever fall below $2,000 you will receive what is known as a margin call which is a request by the broker to deposit enough funds in the account to bring the balance back to the initial margin requirement of $3,000. Usually, these funds need to be deposited with the broker within 24 hours or the brokerage reserves the right to liquidate your position.

At its very core what you need to understand is if you control 100% of an asset with a 3% deposit, in essence this type of leverage implies that a 3% move in the underlying asset will create a 100% profit or loss for the trader.

The reason that most traders lose money in trading is because they are Undercapitalized and Overleveraged.

Brokerage houses in the forex trading arena will give you as much as 500 to 1 leverage. They almost beg you to be undercapitalized and overleveraged. Having 500 to 1 leverage is comparable to trying to drive a NASA rocket ship to your grocery store. I can almost guarantee an accident is going to occur.

Truth be told in forex trading, you as the trader create the amount of leverage that you want.  To most traders this is like a narcotic. They want as much leverage as possible.

Regardless how good of a trader you think you are, your arch enemy is being overleveraged and undercapitalized. The fastest way to lose money is to be undercapitalized and overleveraged.

You’ve probably heard people say that trading forex or commodities is risky. The industry statistics promote that roughly 90% of forex and futures traders lose money. 

Those markets are not any more volatile than stocks, but they are significantly more leveraged and that is what creates the risk and the reward opportunities for traders. Whenever you have 500 to 1 leverage it means that a .2% move in the underlying asset will create a 100% profit or loss for the trader.

Here is how this works in the commodity futures markets.

Let’s say Corn is currently trading at $5.25. Its contract size is 5,000 bushels. Thus, the total value of the contract is $26.520. A trader can create a position, either, long or short, in Corn for the initial margin requirement of $2025. The maintenance margin requirement is $1300.

The margin requirements are dictated by the exchanges where the underlying asset trades.  Sometimes the broker will add a % to the margin requirements to force their customers to be better capitalized.

What this means is that with roughly a 5% deposit, a trader can control $26,000 worth of corn.  If corn moves 5% higher the trader makes 100% profit. If corn moves 5% lower the trader wipes out his account entirely. 

Over the past year Corn has traded as high as $5.41 and as low as $3.32.

Next time you look at a corn chart, look at it through the eyes of a corn trader who is looking for a 5% move one direction or another, to try and make 100% on margin. You will now understand how a market that has a $2.09 annual trading range can create or lose massive fortunes for traders. That $2.09 annual range is the equivalent of $10,450 potential gain or loss for traders who only have to put up a $2,025 initial deposit to be able to trade the asset.

As long as the traders maintain a balance in their account is $1300 or larger (the maintenance margin requirement), they will not receive a margin call. However, if their balance falls below $1300 they will be required to wire more funds into the broker to bring their balance up to the $2025 initial margin requirement.

Worth remembering in forex and futures:

Margin is the deposit needed to place a trade and keep a position open. Leverage, describes the capital outlay required to control the entire underlying asset.  In these arenas you are not borrowing money to trade the underlying asset.

Margin In the Stock Market

Consider the following scenario: you're sitting at a blackjack table and the dealer deals you an ace. You know that you are in the power position now. You’d like to increase your bet, but you are a little short on cash. Your friend agrees to loan you $100 and you can pay him back later.  Now you have a very challenging decision to make. The odds are in your favor but, in reality, you can still lose. If the cards are dealt correctly you can win big on this hand and pay back your friend with the loaned money.  But what happens if you lose?  Well, if you lose, not only will you lose your original bet, but you’ll have to pay back your friend the original $100. Borrowing money in this instance increases your profit potential exponentially, but it also increases your risk.

Whenever you buy stocks on margin, you borrow cash from a broker to purchase more stock using a special margin account. Buying on margin allows you to purchase more stock than what you’d be able to buy with just the funds in your account. Ultimately, doing so ramps up your buying power.

How does margin work?

Individual brokerage firms will offer you a list of accounts and stocks, mutual funds, and etf’s that are marginable. Most brokers will require a minimum of $2,000 in equity in order to access margin through that particular broker.

Buying on margin is literally borrowing money from a broker at an agreed upon interest rate to purchase stock. Simply think of this as a loan from your broker. Having margin trading permits you to buy more stock than you'd otherwise be able to.

An initial investment of at least $2,000 is required for a margin account to buy stocks, though some brokerages require more. This deposit is known as the minimum margin amount. Once the account is opened, approved and operational, you are permitted to borrow up to 50% of the purchase price of a stock. Sometimes brokerage companies will offer you to borrow a little bit more than this percentage. However, 50% is the customary amount for margin account borrowing. 

You must understand that you don't have to margin all the way up to 50%. You can borrow whatever amount you choose and feel comfortable with, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price. At the present time the effective interest rate on margin accounts varies from 6.6% to as high as 9%.

You can keep your loaned funds for as long as you would like as long as you keep your account in good standing with the broker. Whenever you choose to liquidate your stocks the proceeds will first be applied to repaying your loan. All brokerages also have a minimum margin requirement which is the threshold balance which must remain in your account for you to be able to maintain your position. If your account ever falls below the minimum margin requirement you will receive a margin call which requires you to either add more funds to your account to  maintain the initial margin requirement or liquidate your position.

Borrowing money to purchase stocks has its costs which need to be understood for you to be effective at trading on margin.  Whenever you consider trading stocks on borrowed money always calculate the worst-case scenario and include your interest charges.

Pros and cons of margin trading

Most people in developed countries grow up with the idea of using debt to make even more money. If you look at real estate as an example, the majority of homeowners finance their homes usually putting up small down payments.  Using margin to buy stocks is identical in theory to using a mortgage to purchase a home.

Pros  include:

  • The most beneficial aspect to margin trading is the maximized potential returns because of greater leverage.

  • More trading opportunities are available because of the amount of buying power you have while trading on margin.

  • You can employ more advanced strategies which often can include income producing options trading strategies.

  • Interest on margin loans is usually tax deductible against your net investment income.

The massive gains that come with margin-fueled bull run are matched only in intensity by the catastrophic drawdowns that even a very modest price declines can wreak upon anyone who is overleveraged.  If we look at the Great Financial Crisis of 2008, Financial services giant Lehman Brothers had $22.5 billion in assets, but they were carrying $680 billion in subprime mortgages.  This amounted to a 30 to 1 leverage ratio. All that it took to make Lehman’s stock worth zero was a 4% drop in its sub-prime portfolio.

Many consider Warren Buffett to be the greatest investor in the world. Mr. Buffet doesn’t use any margin to amplify his returns. While it is interesting to ponder how much better his returns might be if he did, it is equally important to contemplate that generating positive returns in the markets requires first and foremost your ability to effectively hold on to your position. If you are highly leveraged this is much more difficult to do.

Risks, include:

  • You increase risk whenever you trade on margin. You could lose your initial investment, plus what you borrowed from the broker.

  • Become aware of the additional costs (interest expenses) through the broker to hold your position.  Borrowing funds on a trade that goes sideways still requires you to pay the additional interest cost.

The Federal Reserve Board regulates which stocks are marginable. Brokers will not allow customers to purchase penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the large day-to-day risks and market fluctuations of these assets.

Here's the bottom line on margin trading:

  • Buying stocks on margin is borrowing money from a broker to purchase additional stock.

  • Margin increases your buying power.  But it also increases your risk.

  • An initial investment of at least $2,000 is required to open a stock trading margin account (minimum margin).

  • Brokerages allow you to borrow up to 50% of the purchase price of a stock (initial margin).

  • You are required to keep a minimum amount of equity in your margin account that can range from 25% - 40% (maintenance margin).

  • The value of your securities act as collateral for the loan.

  • Like any loan, you’ll have to pay interest on the amount you borrow.

  • Not all stocks qualify to be bought on margin.

  • If the equity in your account falls below the maintenance margin requirement, the brokerage will issue a margin call.

  • Margin calls can result in you having to liquidate stocks or add more cash to the account.

  • Become aware of how much leverage you are creating whenever you trade on margin.

  • The advantage of margin is that if you pick right, you can win huge.

  • The disadvantage is that if you pick wrong you will lose huge.

  • The downside of margin is that you can lose more money than you originally invested.

  • Margin trading increases risk.

You are more likely to lose lots of money (or make lots of money) when you invest on margin.

The mark of a great trader is not how much they make when they are right but rather how little they lose when they are wrong. In all of the trading and studying I have done I have discovered that my leverage threshold is around 3 to 1.  What this means is that for every $1 in my trading account I am controlling $3 of the underlying asset.

Whenever I cross that threshold I lose my objectivity and trading becomes stressful. I urge you that you discover your leverage threshold by opening a demo and practice keeping your positions small so that you can keep your objectivity and trading to be as stress free as possible.

Most super high leveraged traders usually blow themselves up long before they hit their 100th trade. Learn from their tragic experience and make sure you don’t repeat their results.

Great traders look for consistency in their trading results.

I track all of my trades and every hundred trades I develop my metrics.

What was my average winning trade?

What was my average losing trade?

What was my biggest win?

What was my biggest loss?

This discipline has been necessary for me to develop an understanding of what it takes to be successful in trading.  By doing this I have developed huge confidence in my abilities. This confidence has been a result of tens of thousands of trades and learning from my mistakes.

I've learned instead that trading is largely defensive. If I take care of my losers as a top priority the winners will take care of the rest.

In trading you have to become expert at taking losses, and not looking back.  This is much easier said than done.  But if you recognize that your ego is the enemy, taking losses becomes an essential part of the activity.

Risk is by definition the threat of loss due to uncertainty. 

A great trader does not have to have all the facts to be able to act upon a solid trend that is in motion. Trading at its essence is finding a strong trend and deciding where you get in and where you get out. Ideally what a trader wants to know is where do the strongest trends exist.

This is why artificial intelligence is an absolute necessity for traders today. Look at the following chart of the S&P 500 Index with the Vantagepoint A.I. Forecast.

This forecast has proven to be up to 87.4% accurate in predicting the future trend of the stock market.  I think you’d agree that is far more impressive than any of the narratives you just read about.

Our forecasts are created by looking at the top 32 drivers of an asset's price. We do this from the foundational perspective that we live in a global marketplace. What happens in one part of the world has global implications and your charts and analysis need to communicate this information to you before you ever think of putting on that next trade.

Moving forward I want you to think long and hard about HOW you are going to trade the markets if you do not have an edge. As the volatility of the past few months becomes commonplace are you prepared?

Think about those losing trades and ask yourself what did you learn from that experience? What is your method for analyzing risk?

Are you capable of finding those markets with the best risk/reward ratios out of the thousands of trading opportunities that exist?

Knowledge.  Useful knowledge.  And its application is what ai delivers.

Artificial intelligence is not “a would be nice to have” tool. 

It is an “absolutely must have” tool to flourish in today’s global markets.

Intrigued?  Visit with us and check out the A.I. at our Next Live Training.

It’s not magic.  It’s machine learning.

Make it count.