In the words of the most successful investor of all time, there are three ways to go broke: liquor, ladies and leverage. Warren Buffett was not wrong when he said this as leverage is a double-edged sword in stock trading. With margin rates and leverage at a dangerous level, you can go from rich to broke in minutes.
Thankfully, you have Bullish Bears. Though we can't help you with numbers one and two, we most certainly will try with number three.
What Is Margin?
- At its most basic level, margin is money borrowed from your brokerage firm to buy securities. The amount your broker or bank will loan you is based on the amount of money you have in your account.
1. Margin Rates Key Takeaways
- Buying on margin is the act of borrowing money to buy securities.
- Margin allows the trader to buy more securities than what they could otherwise buy with the balance in their account
- You, the "borrower," only pay a portion of the cost
- Your broker or bank will loan you the money and uses the securities in your account as collateral.
- Brokers charge margin rates or interest on the loan
2. Margin in the Trading World
Margin is the amount of equity a trader has in their brokerage account. When we buy on margin, we borrow money from a broker or banker to purchase securities. To do so, you must have a margin account as you can't borrow on margin with a standard brokerage account.
Without a doubt, margin trading can be advantageous where you think your ROI would be much higher than the loan's interest rate.
3. Who Trades on Margin?
Many day traders use margin (borrowed money) to have access to significant amounts of capital otherwise not available.
Let's say you only have $10,000 cash in your trading account and you want to buy shares in Facebook. With $10,000 available, you can only purchase about 34 shares ($10,000/$287).
However, if you have a margin account with 3:1 leverage, you can purchase 104 shares. How does that work?
Well, 3:1 leverage means your $10,000 allows you $30,000 of borrowing power, which translates to 104 shares ($30,000/$287).
In this scenario, $20,000 was borrowed from your broker, so you need to pay interest on the borrowed amount. This is no different than if you borrowed money from your bank.
Is Margin Trading a Good Idea?
- There are two fundamental reasons that traders love to trade on margin.
- Access to capital well beyond what's in their account
- The potential of significant returns on investment
- Some investors borrow on margin as a form of arbitrage.
- To do so, you borrow money at lower margin rates than a stock's dividend payout rate, and you pocket the difference between the two.
1. The Risk of Margin
Did you know that traders can lose more money than what they trade with? Yes, this is possible. At this point, I need to talk about the elephant in the room: Margin trading.
Things typically go sideways for many traders when they use margin or "borrowed money" to trade. As mentioned earlier, margin trading can amplify gains as well as losses.
The example below shows how it is possible to lose more than 100% of your investment by trading on margin.
In the example above, you're theoretically on the hook for $20,000. What happens if some unexpected event occurs, such as a global pandemic which wipes stock prices off the map?
Well, it happened in March of 2020, where FB saw their share price take a 50% haircut. If you "borrowed" $20,000 to buy 104 shares at $287 and the share price dropped to $100, your investment is only worth $10,400.
Do the math, and you're out $19,600. Ouch.
But it gets worse.
In addition to losing your entire $10,000 investment, you're also on the hook to your brokerage account. You have to repay them the margin loan of $20,000 plus the interest or margin rate on the loan.
In most cases, you are paying a hefty premium. If your margin rates are 10%, you're forking out $2,000 interest every month for the loan. Gross. Personally, I don't use margin that much. In fact, it scares me to death.
2. Margin Rates of Some Common Brokerages
In the table below, you'll see that most brokerages are sitting pretty from the cash they make off interest. A lot of brokers, such as Interactive Brokers, charge margin rates on a sliding scale. On a positive note, they have some of the lowest margin rates in the industry.
3. Calculating Margin Interest
Back to Facebook. In this scenario, let's say you want to borrow $30,000 to buy shares before earnings.
You've done your homework and think the stock will soar during the earnings release in 10 days. You plan to hold the shares for ten days at a 6% (annual) margin interest rate.
To calculate how much this margin loan will cost you, take the amount you borrow and multiply it by the margin rates:
- $30,000 x .06 (6%) = $1,800
Next, you multiply $1,800 by the number of days in a year. Typically the brokerage industry uses 360 instead of 365.
- $1,800 / 360 = 5
Finally, you multiply five by the total number of days you plan to borrow.
- 5 x 10 = $50
The end result is a $50 charge to borrow $30,000 for ten days.
4. An Alternative Way to Secure Margin
Personally, with the high-interest rates, I wouldn't be going to my broker for a loan. I suggest you go to another source such as your bank for a short-term loan if you want to invest.
Loan interest rates may be better than margin rates. So whether you're day trading stocks or options, make sure you have the money for it.
Margin Rates Final Thoughts
Margin can be a powerful tool if used carefully. Trading on margin without proper risk management strategies in place can and will put you into debt fast.
As a matter of fact, many traders fail before they even get started because they haven't built their foundation of knowledge and skills. Margin rates won't help that.
Without a solid foundation, you might as well head to Vegas and gamble your money away. No one wants to go broke, me included.
Although we can't help you with the ladies and liquor, we can teach you how to grow your money, not throw it away.