Margin trading refers to the case where one borrows money from a broker to trade. It evokes mixed reactions. Some embrace it with open arms. Some view it with a good dose of cautiousness. Others avoid it at all costs seeing it as a sure recipe for disaster. Actually, all views are valid. It all boils down to how much you know. If you fully understand how you can make use of margin trading and its risks, then go ahead. Or if you are only just starting out, then make sure you do your homework and approach cautiously. But if you know nothing about it, then my advice is "Don't Touch It".
If you decide to look into margin trading, then here are 5 things you should know.
1. Financing costs vary across different brokers
Brokers have their own way of determining how much interest you should pay for what you borrowed. It is usually based on some reference rate plus a spread. The reference rate could be something based on the Fed Funds Overnight Rate, the relevant LIBOR rate, or whatever methodology the broker chooses to use. The spread is what you need to pay over and on top of the reference rate. And it is "theoretically" what the broker makes from lending you the funds assuming the reference rate is what it costs them. However, not all brokers are transparent with how they derive their charges.
And depending on how much you borrow, the financing costs may differ as well. There is the economy of scale. The more you borrow, the lesser the interest (percentage-wise) you pay. Again, the exact mechanism is up to the individual broker. But what you need to know is this: what you pay at the end can be hugely different between brokers.
The table above compares the margin financing rates across 3 brokers - Interactive Brokers, TD Ameritrade, and POEMS. As you can see, the range is huge. We are not talking about a few or even tens of basis points here. The difference is in the order of a couple of percentage points. And that can make a significant impact on your returns. So if you intend to borrow significantly, do watch out for this.
Note: This does not mean you pick a broker based on how much they charge for margin financing. Margin financing is only one aspect of what a broker charges. If you are not going to trade on margin, or just going to borrow a very small amount, or perhaps you trade intraday, then margin financing is probably not your main concern. So depending on your needs, you will have to evaluate other things as well such as commissions if you trade frequently, securities borrowing costs if you short, size of your trades, fractional shares for precision, algorithmic order types, market access, real-time price data, monthly platform fees or custodian fees, etc.
2. You need to satisfy the margin requirement to hold on to your positions
When you borrow money, lenders can ask you to put up collateral. In a mortgage, the house is your collateral. And in the case of margin trading, the securities or assets you hold become the collateral. To purchase securities, you need to have enough on hand to satisfy what is called the margin requirement. You can see that as the collateral required.
There are different methods to calculate the margin requirement. It can be based on a percentage of the value of securities purchased or based on risk. The latter is more complicated. In any case, let's focus on the easy one just to understand the mechanics involved.
Let's say on Day 0, you have $100,000 and you borrowed $50,000 from your broker to purchase $150,000 worth of securities. And the margin requirement is 50%. That means you need to have at least $75,000 after liquidating all your positions. And since your account holds $100,000 at this point, you can maintain the positions.
Then on Day 2, your securities suffer a loss of 20% and its value drops to $120,000. Based on that, you are required to put up a margin of $60,000. And since your account is still worth $70,00 if you liquidate everything, you can continue to hold the positions.
On Day 3, your securities are hit by another loss of 18.3% and its value drops to $98,000. This means a margin requirement of $49,000. But your account will only have $48,000 at this point. So you can no longer maintain your positions unless you inject more capital.
Note: What I illustrated is a simple case of end-of-day margin requirements imposed by US regulators. Brokers, however, can track margin on a real-time basis using another set of calculations.
3. Your positions can be forced liquidated in margin calls
If what you have falls below the maintenance margin requirement, you will get margin calls. As mentioned, it means you no longer hold enough collaterals (cash or securities) to maintain the amount of money you borrowed from the broker. So the broker notifies you to top up. And if you fail to do so, they will force liquidate some of your positions.
This mechanism can worsen an already deep market rout. Just imagine the brokers selling their clients' holdings after an already steep selloff. That will of course make prices dive even further. And every once in a while, some big players will make the headlines after getting whacked severely by margin calls.
So why do we have margin calls in place? Actually, it helps to safeguards both brokers and clients. If you are the broker, you wouldn't want to lend too much money to your clients. Because when the market crash suddenly, it is possible for your clients to lose till they are unable to pay you back in full. And their losses become yours until you can recover them. FX broker Alpari UK went into insolvency because of this when the Euro-Franc trade turned awry after the Swiss Central Bank unexpectedly scrapped the peg to Euro in 2015. But on a positive note, this also prevents overly aggressive clients from getting themselves burnt.
4. You should understand the concept of leverage in margin trading
You may hear of the word leverage in investing. It is a generic term that refers to the use of borrowed funds to trade or invest. There are other ways you can access leverage besides borrowing money from the broker through a margin trading account. For example, you can borrow money elsewhere aside from the broker. There are also financial instruments that come with embedded leverage such as futures, options, leveraged ETFs, etc.
As an example, you can buy an emini S&P 500 futures contract worth $220,000 at the point of writing just by putting up a margin of around $20,000. And in this case, you are not borrowing from the broker so you do not need to pay interest to them. But of course, there is no free lunch here. Because the financing costs are already priced into the futures contract.
Now, the idea of leverage is easier to grasp because it is very intuitive. It is the total value of your securities or positions against what you have if you liquidate everything. As an example, let's fall back on the earlier scenario where you had $100,000 and borrowed $50,000 from the broker to buy $150,000 worth of securities. In this case, your leverage is $150,000 / $100,000 or 1.5. So if the value of securities drops 10%, you would lose 15%. Leverage gives you a more direct sense of the risk you are taking.
5. You should always consider the risk-reward of your strategy to assess if leverage with margin trading is worth it
We all want to be adequately compensated for the risk and costs we take. Just like running a business, if costs outweigh revenues, then this business will fail if nothing changes. The same thinking applies when you want to borrow funds to trade. For example, if your strategy only returns you 5% annually, you wouldn't want to borrow funds that charge you 6% a year. That is plain common sense unless you just want to make your broker rich.
Thus, margin trading is advisable only if you can make more than what it costs you to borrow those funds. And not just marginally more. You need a good buffer of safety. Why? Because while your financing costs are known, your returns are not guaranteed.
In general, the riskier your investment, the greater the uncertainty in your returns, and the higher the buffer needed. It is not worth paying 5% a year to make 6% in investment unless they are more or less guaranteed. You might as well just put your money in a fixed deposit. But a well-managed and diversified portfolio running a low risk with an annualized return of 11%-12% is a suitable candidate (see our multi-strategy portfolio model that can be implemented through iFAST Global Markets)
Trade with a good dose of cautiousness
While margin trading is appealing, bear in mind that it is also a double-edged sword. With interest rates at an all-time low in history, investors are piling in borrowing money and pumping it into risky assets such as stocks. And excessive leverage in the financial system is frequently a precursor for a major crisis. It accelerates everything when things turn nasty. So trade well but don't forget to trade cautiously as well.