Trading accounts and margin are key tools for anyone who wants to make money in the markets. Margin accounts allow traders to borrow money to exaggerate their trading performance. They are a must for all traders as well as for the experienced long-term investor.
Misinformed market participants and observers share a common belief. They often associate heightened risk with the use of margin accounts. But this association is mistaken.
Margin accounts are nothing but a tool. They are no more dangerous than a sharp knife or a fast car if the operator knows what they are doing.
Use margin accounts right, and they will help your trading. Use them wrong, and just like a sharp knife they can cut.
In this article, we’re going to cover five key things to know about how margin accounts work. You’ll learn how to use this tool in the best way to get the results you want.
Trading Accounts – How Margin Works #1: Comparison to a cash account
Let’s use a comparison to better understand how a margin account works. Enter the cash account.
A cash account is one where all transactions happen with the account holder’s deposited money.
HERE’S AN EXAMPLE OF A CASH ACCOUNT:
John has a cash brokerage account with $1,000. He buys 10 shares of a stock worth $50 totaling $500. Those shares go to $55 where he sells. The $550 proceeds get added to his account balance, and now John has $1050 in his cash account.
Trading with a cash account is pretty straightforward. Little to no imagination is necessary. The money you have is the money you can put at risk in the market.
But for serious traders, you will likely use a margin account once you are proficient at trading. So let’s learn more about this important type of account…
Trading Accounts – How Margin Works #2: It’s really just a form of loan
“A rose by any other name would smell as sweet.” – Juliet in William Shakespeare’s Romeo and Juliet.
No matter what you call it, using margin means that you are borrowing money. When opening a margin account, it’s far from magical or complicated.
You are signing on the dotted line saying that you would like the ability to borrow money. And that borrowed money goes towards buying and selling financial instruments as necessary. Compare the example below with the cash account example from the previous point.
HERE’S AN EXAMPLE OF A MARGIN ACCOUNT:
Randy has a margin account with $1000. He buys 30 shares of a stock worth $50 totaling $1,500. $1,500 is greater than Randy’s $1,000 current balance. His margin account allows him to borrow the $500 shortfall.
Of course, the brokerage will charge Randy interest for every day that he continues to borrow. Randy sells his shares at $55 and makes a $150 profit.
If Randy were using a cash account, he would have only been able to buy 20 shares. If he had bought and sold at the same times as the example above, he would have produced a profit of $100 instead of the $150.
Remember that Randy incurred an interest charge. Let’s say his holding time was 1 month. The interest rate that he paid was 3%. His brokerage would have charged him $1.25 in interest.
That’s 3% per year divided by 12 months. Multiply that by Randy’s 1 month holding time and by the $500 Randy had to borrow.
The $500 comes from the $1,500 stock buy minus the $1,000 in cash that Randy already had.
“A margin account means you are borrowing from your broker (and will pay interest on this loan).”
Traders are often willing to pay the interest to buy financial instruments. They do it because of the belief that the potential gains will surpass the cost of the interest. Margin can increase your trading leverage, and this makes it a key tool in your trading arsenal.
Trading Accounts – How Margin Works #3: Level and inbuilt borrowing
Stock and Forex trades that exceed the cash in a margin account use account level borrowing. The broker is lending you the shortfall in the money necessary and charging you interest.
Then there are “inbuilt” interest products. Options on stocks, commodity futures, and options on futures fall into this category.
The way it works is that the value of the product decreases as time passes. Since there is no interest charge, a trader does not see it. The best way to think of it is the market takes the interest away behind the scenes.
With account level borrowing, traders see the interest expense deducted in their accounts. In this type of borrowing, you are able to see how much you paid in interest at the end of every month and year.
Leveraged financial instruments with inbuilt interest are different. They have a component of price movement that adjusts for the built-in interest. And that interest is measurable but ignored by most.
Let’s look at an example:
Here’s why you are getting charged interest. An ES S&P500 Emini contract has a value of 50 times the value of the S&P500 index. If the index is at 2,200, the value of the Emini contract is $110,000.
A trader buying the contract requires $5,000 to buy the contract that has a future value of $110,000. That means that $105,000 represents a borrowed amount. This interest value is a part of the contract and fades as time passes. The reason why many people do not think about it is that it’s a minor factor. But it’s only minor compared to the other influences moving the price of the futures contract.
The inbuilt interest components of futures and options contracts are somewhat insidious. You never get a exact account of the fact that it is happening. But the plus side is the amount is tiny in comparison to the other considerations that impact price.
Trading Accounts – How Margin Works #4: The double-edged sword of leverage
The cliche that leverage is like a double edge sword is appropriate here. Leverage amplifies a trader’s ability to make money. It also increases the speed at which a trader can lose money.
Let’s go back to Randy from our earlier example…
THE CASH SCENARIO:
Randy has a cash account with $1,000. He buys 100 shares of a $10 stock. The stock goes up to $11. Randy sells for a 10% gain, and his account is now at $1,100.
THE MARGIN SCENARIO:
Randy has the same $1,000 in a margin account. He buys 200 shares of a $10 stock. The $2000 purchase breaks down into $1,000 of Randy’s cash and $1,000 of money borrowed on margin. The stock goes up to $11. Randy sells. He repays the $1,000 he borrowed, and the remaining $1,200 in proceeds go into his account. The use of the margin account in this example took the same 10% gain in stock price and amplified it to 20%. Randy’s account balance now sits at $1,200.
It is important to note that Randy could have been wrong on his trade. Instead of amplifying his gains, a 10% loss in stock price would have meant a 20% loss in his account value.
Trading Accounts – How Margin Works #5: Zero is not rock bottom with margin
With a cash account, the most you can lose is 100% of your money. A trader with 100% of their money in one stock that goes to $0 only loses their entire account. The despair is real, but it could have been worse.
Consider a trader who bought the same stock headed to $0. With a margin account the trader buying $1,000 with cash and borrows another $1,000 on margin.
When the stock becomes worthless, our unfortunate trader has lost his own $1,000 as well as the $1,000 he borrowed. He now owes his broker $1,000.
Yes. That’s right. He is now in debt.
Before comprehensive risk management systems, traders would get a margin call. A margin call is when a trader’s account value gets so low that the broker will call the trader.
The broker will demand that they reduce the risk by closing the position. The broker can also demand that money gets added to the account immediately.
Most firms now have a computerized system watching a trader’s equity levels. Before a trader can owe any money to the brokerage, the broker will close the position. The broker is forcing the trader to close the position.
This may not be ideal for the trader. But the broker has a business to protect as well. The conflict is that the trader’s willingness to risk exceeds the broker’s.
In an ideal world, this happens before the account balance becomes negative. Unfortunate exceptions to this occur.
Unexpected gaps in price can happen. This means that the best price when closing a position can still result in a loss. And that loss can be greater than the trader’s remaining equity in the account.
The Key Takeaway…
Margin accounts and their associated leverage are fantastic tools. Accomplished chefs love their sharp knives. Professional race car drivers make the best of their fast performance vehicles. The tool should never be at fault for the folly of an inexperienced or incompetent operator.
What You Can Do To Stay Safe
Trading markets will always be around providing opportunities for traders and investors alike. There is no need to rush. Start off trading with a simulated account to get used to how things work. Then move to a cash account if possible and attempt to replicate your simulated results. Finally, amplify your results in a margin account using leverage in a responsible way.
For more day trading techniques, tools & strategies, check out these articles:
- 4 Ways To Size Day Trading Accounts
- Online Trading Brokers & After Hours Trading
- 13 Essential Day Trading Tools For Success
Make sure you understand margin and cash trading accounts before you jump in and open one. It’s better to know up front than to find out how they work the hard way.
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