What is trading with Margin?
Trading with margin is simply using borrowed money to buy or sell stocks short. Brokerage firms will allow you to use your cash on hand as equity in determining the amount of margin you are allocated in your trading account.
This leverage is different for the types of markets you are trading (i.e. forex, futures), but for the purpose of this article our examples will focus on a standard margin account.
For a standard margin account your brokerage firm will offer you twice the value of your cash on hand. So, if you have $100k cash, your brokerage firm will allow you to use up to $200k.
Now in terms of day trading, you will need a minimum of $25,000 cash in your account (thanks to the SEC) and your brokerage firm will extend you four times your cash. So, if you have a $100k cash, your brokerage firm will allow you to use up to $400k for your day trading activities.
Now that we have covered the definition and basics of margin, let’s dig into how you can use margin when trading.
How Much Margin Should You Use?
The first question you have to ask yourself is how much margin do you want to use? Please do not make the rookie mistake of using the full amount extended to you by your brokerage firm. This is a clear sign that you are coming from a place of greed and not effective money management.
Let me help you out on this one if you are unsure. For my trading account I can use up to 150% of my cash on hand. 150% feels just right to me for a number of reasons:
- I am swing trading, so I’m not using all of the available funds which helps me fight the greed factor
- 150% allows me to avoid a margin call (we will cover this later in the article)
- By not overextending myself, I avoid the scenario of getting caught up in a sharp market correction
- Based on the volatility of the stocks I trade, I am able to use this amount of margin without getting in over my head
As you think through how much money to use, don’t go too granular. What you really want to focus on is managing the risk and less about money.
If you trade biotechnology companies with extreme volatility, you will likely want to use your cash. If you are trading large-cap stocks like MSFT or IBM, you can use more margin as sharp price moves are less likely.
Only you can answer this question, but over time you will find the right amount of exposure that feels right for to you for your trading account.
When are You Ready to Use Margin?
People think that using margin only comes down to your skill level. Meaning that if you are a good trader you can just run out there and trade up to your available margin.
This on the surface makes sense, but if you are a successful trader, why not use more money? Doesn’t this mean you will just make more money per trade since you have already proven yourself to be a winner?
Well, yes and no.
Using margin is one of the quickest ways you can “blow” up your account. When I say blow up, I mean that you can take a perfectly good account with a solid trading performance and due to overleverage have a massive drawdown of your equity.
Remember, it only takes one bad trade to ruin months’ worth of work.
Using margin comes down to your ability to manage risk and has very little to do with how good you are as a trader.
How to Allocate the Additional Capital
The short answer is that you use margin in the form of a pyramid. This means that you have to build a solid foundation of winning trades and then add on to these trades up to the margin limit that you have defined.
Let’s look at how I manage my trades as a real-life example. I can use up to 150% of my trading equity. So, if I have $100k cash this means that I can trade up to $150k.
Next I divide that $150k into fifths. This breaks down to $30k per trade.
In terms of my pyramid, I can only put on 3 trades to start. This means I will only be using $90k, which protects me by only using my cash. At this point, in order to add another position, one of my existing positions must have a stop that is above my entry point. This basically means that the risk in my existing trade has been greatly reduced. Now that the risk has been removed from my existing position, I can add another position if I see fit.
I will repeat this process until I am carrying a total of 5 positions with 150% of my equity in float. This allows me to trade larger without placing myself in a situation where I could potentially blow up my account.
If you are a day trader, please visit the article How to day trade with margin, which goes deeper into the topic of intraday trading and managing the increased leverage.
When You Should not trade with Margin
Most people would respond to this question with, “If you are on a losing streak”. This is pretty obvious, but let’s take this a step further. Let’s say you are not using the pyramid method I described in the previous paragraph to manage your account and you are just out there swinging for the fences. Below are a few questions that if you say yes to, you are one bad trade away from blowing up your account:
- Is one of your positions so concentrated, that if you lost everything on the trade you would end up owing your brokerage firm money?
- Are you constantly receiving alerts from your brokerage firm that you need to deposit more funds or liquidate a portion of your position?
- Do you use margin to continuously add to a losing position as it goes against you, because you know at some point things will turn around?
- Do you feel like you are out to defeat the market?
- Are you trading for the wrong reasons (excitement, get rich quick, etc.)?
- Does your account experience dramatic swings up or down?
Real-Life Example of Trading with Margin
From the end of January through February 6th, the market experienced a pretty severe correction. Stocks were falling like bricks. I was able to avoid the bulk of the blood bath, but I did enter the market a few days early, so I had to sit through a bit of the noise before the market began rallying.
Sticking to my pyramid structure for using margin, I was only long cash in early February.
Imagine though if I had gone in 200% long. Would I have had the same perspective? Would I have panicked because every tick against me would have moved me closer to the edge?
Short Selling and Trading with Margin
Trading with margin while shorting is a different game altogether. Unlike going long where the gains are unlimited, when you short, the risks are now unlimited.
This is why when it comes to shorting, I do not use more than my available cash on hand. I take the total cash value in my account and divide that by three.
I am probably leaving money on the table by not using the additional leverage; however, I know myself and I know I don’t like situations that can get out of hand.
Another way to look at this is that bear corrections are often short lived but very profitable, so it’s not about using a lot of leverage, as the market will provide more than enough to the astute investor.
What to do when hit with a potential Margin Call
If you find yourself “jammed” up and a margin call is unavoidable, don’t beat yourself up over it. First, look to liquidate the position that is causing you the greatest amount of risk.
Your money management is all that matters at this point. It’s not about you being right. So, don’t let anything get in the way of protecting your capital.
Contrary to popular belief, trading with margin is not some overly risky endeavor. If used with the proper money management principles, the use of margin can allow the skilled investor to grow their account value exponentially.
The tough question you have to ask yourself is if you are at a point in your trading career where you can do so successfully?