Buying on Margin Explained – What It Means and How It Works
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If you invest $5,000 in stocks with an annualized return of 10% (the average return over the past 10 years in the S&P 500), you’ll make $500 annually. But what if you would have borrowed money from your broker to buy even more stocks? Is this a good idea?
When traders borrow money from their broker, either on intraday or overnight margin, then leveraging the investment amount is precisely the idea they have in mind. What can be overseen when too excited is that the leveraged profit potential is also a leveraged loss potential. Margin trading always works well if the investment goes in the intended direction.
If an investor borrows money to hold stocks for a few months, the leverage works in his favor. If a trader trades on intraday margin, it works as long as the profits come in. However, buying on margin can be challenging if things go in the opposite direction, for investors who now have to fight against inflation-influenced markets or day traders who don’t have the same volatility as in 2020/2021.
But how exactly does buying on margin work? Here is everything you need to know about it.
How Intraday Margin Trading Works for Day Traders
Day traders open and close their positions during one trading day. The earliest time to open a day trading position is during pre-market hours, while the position gets closed by the latest during after-hours trading. Nonetheless, in 99% of cases, day traders open and close their positions during regular trading hours.
Day traders in the U.S. need to open an account with a minimum of $25,000 to be eligible to day trade more than 3 times per 5-day rolling period. In most cases, those opened brokerage accounts are margin accounts, where the broker automatically borrows money from the trader if needed for intraday purposes.
The great thing about intraday buying power on margin is that it typically comes with 0% borrowing fees.
So how does it work?
Let’s say you opened your brokerage account as a margin account and funded it with $25,000. With most brokers, you now have an intraday buying power of $100,000. Open your trading platform and check the balances. You will see that your broker typically allows you to use a leverage of 1:4, so for each dollar you have in the account, he will give you $3 for free (look out for something like “intraday buying power”).
Under the assumption that one stock of stock exchange listed Broker XYZ costs $25, you can buy 1,000 shares with your own funds plus 3,000 intraday with your borrowed money in the margin account. That means you can control positions with 4,000 shares of Stock Exchange listed Broker XYZ for day trading purposes.
Example
- Without margin: You buy 1,000 shares at $25 and sell it intraday at $26 for a $1,000 profit (($26-$25)*1,000 shares)
- With margin: You buy 4,000 shares at $25 and sell it intraday at $26 for a $4,000 profit (($26-$25)*4,000 shares)
As you can see, the profit potential is immense and considering that the borrowed money is free to use, it’s a great opportunity if you are good in day trading.
How Overnight Margin Works for Investors
Buying on overnight margin for investors slightly differs from the way how buying on margin works for day traders. That’s because there is a high probability of price changes while the stock market is closed in the underlying asset the investor purchased. Stocks seldom open at the same price where they closed a day before.
And if there was any company news like earnings or stock market influential updates while the market was closed, or massive gains or losses on stock markets in Asia or Europe, the NYSE and Nasdaq-listed stocks are likely to gap up or down, which increases the risk for the investor, but also for the broker who borrows the money to the investor.
That’s why most brokers reduce the overnight margin to 1:2. So, for every dollar you have in your brokerage account, you can invest two dollars.
Risks of Buying on Margin
Where is light, there is shadow. That’s also true for investing and trading on margin. Trading with borrowed money requires excellent money management. Open positions must be monitored and managed properly since every mistake now hits you with leverage. Let me visualize the risk more clearly so that you can understand the real risk of buying on margin better.
Hypothetical Example
Without Margin: You fund your account with $25,000 and invest $25,000 in 1,000 shares of stock exchange listed broker XYZ. After the market close, the bank publishes earnings results which cause the stock price to fall by 50%. The next day, you realize that you lost $12,500 of your portfolio value overnight. This is already a big challenge since you now have to make 100% doubling this amount just to come back to your original balance.
With Margin: You fund your account with $25,000 and invest $50,000 in 2,000 shares of stock exchange listed broker XYZ (50% of the position is financed with overnight margin). After market close, the bank publishes earnings results which cause the stock price to fall by 50%. The next day, you realize that you lost $25,000 of your portfolio value overnight. You now realize that you lost everything. The remaining $25,000 owns the bank since they borrowed you this money. Your remaining balance is $0.
Worst Case: The more you leverage your positions, the higher the risk. The worst-case scenario for such investments is that you lose more money than you have funded. If the stock would gap down 75%, you would then owe the bank money they borrowed from you since you can’t give back the money after the market opens.
Can I Go Short on Margin?
Yes, you can go short on margin. Shorting stocks can be done on leverage in a similar, but not the same way how it works for long positions. The online broker is aware of the higher risks of short positions and therefore cuts down the intraday margin and the overnight margin for stocks. While the leverage remains relatively high for large-cap stocks, it can go down to a 1:1 ratio for small-cap stocks and penny stocks.
The concept of shorting stocks on margin is similar to going long but with the reverse intention. Those who go short speculated on falling stock prices. Therefore shorting on margin is only profitable as long the chosen market or stock declines. And there is an exceptionally high risk of going short on margin since the risk is nearly unlimited.
Example: You short a penny stock that, as long as you have monitored and backtested it, always fell when it gapped up at the open. So, let’s say penny stock XYZ closed the day before at $2 and gapped up this morning by 100% to $4 per share.
As your backtest results suggest, it is a g reasonable strategy to short the open aiming for a retracement back to the previous day close. So you are short 10,000 shares for $4 each. Your short position now has a value of -$40,000, and you want to buy back at $3 for a profit of $10,000.
Intraday, things go well, and the stock retraces to $3.5. You know that you should close that position (currently $5,000 in unrealized profits), but for whatever reason, you get hit by the fear of missing out and want to buy back at $3 as originally intended. So you decide to hold the short position overnight.
For the broker, its okay since you bring in $25,000 of the risk, and he only has to provide $15,000 in funds for a leverage of 1:1.6. But now the unbelievable thing happens. The reason for the upgap was a new product that would revolutionize the financial markets, and a merges & acquisition deal gets proposed after the market close.
As a result, the stock gaps up to $10 the next day. What does that mean to your position? You shorted 10,000 shares for $4 each. Now you have to buy back 10,000 for $10 each. The loss is 10,000 shares * -$6 per share for a combined loss of $60,000. So you lost $25,000 of your own funds, and in addition, you owe your broker $35,000, and he wants the money now!
Risk Management
Buying on margin equals high risk, especially considering that most day traders but also investors lose money. Therefore, margin investing is typically better used by hedge fund managers, finance professionals, and mutual funds.
That’s not because certain people know more about it, it’s because they have the better risk-assessment tools in place and often automatically adjust positions in their billion-dollar portfolios.
Risk of a margin call
If you check your trading platform info, where you find the buying power and intraday-margin insights, you will also find the maintenance margin value. If the value of your owned funds (without the borrowed money) falls below the maintenance margin, the broker will issue a margin call.
As a result, you have to either immediately transfer additional funds to your brokerage account, or the broker will close open positions (or some parts of the position to get back above the maintenance margin requirements).
If you look at the example about shorting on margin, you will realize that the broker can get in trouble if you can’t pay back the funds you owe in case unexpected things happen. So, the broker does this to prevent potential losses and can do it without your approval, which reflects a downside risk for the investor who heavily invested with margin.
Costs of Margin
A margin by a broker is a loan, and the margin loan rates currently range relatively wide but high, between 5 and 15 percent, depending on the broker. The rate fluctuates depending on the federal funds rate, but costs can add up quickly. Therefore, investors should be more than careful using margins for trading.
The Problem of Avoidance of Margin Accounts
You belong to those investors who make rational decisions. Your trading and investing is dominated by decisions based on proper stock research and due diligence. You sometimes make day trades, but now too many. So you decide it’s best to use a cash account instead of a margin one.
This way, you want to avoid getting trapped by the margin leverage problem. But here comes the problem. The settlement date with a margin account is 0 days, while the settlement date for a cash account is x+1 or even x+3 (3 days after you sold the position). That means without a margin account, to have to wait until the money is settled.
That means that if you sell a position, you need to wait until the money is settled before you can invest again. This makes it nearly impossible to day trade, but also difficult to do proper rebalancing in your investment account.
Benefits of Buying on Margin
The main benefit of buying on margin seems to be the high leverage, which can potentially increase profitability. But there is another benefit that weighs more, in my opinion. As said earlier, a margin account immediately credits the funds received from selling financial assets (stocks, ETFs, etc.).
Those funds are immediately available to re-purchase stock, options, etc. This is especially beneficial for investors who rebalance their portfolios on specific dates. Let’s say you want to rebalance your investment portfolio. You have stocks, mutual funds and ETFs in the portfolio, and the total value of the position is $48,000.
You also hold $2,000 in cash. It’s the middle of December, and you want to overweight stock, reduce your mutual fund exposure and reallocate funds assigned to the ETFs. In a cash account, you can sell all of your positions, but you have to wait up to 3 business days until the money is available for buying again.
But if you have a margin account, you can immediately rebalance your entire portfolio within seconds. This is where the real benefit for investors is.
And the same benefit goes for day traders. Even if you don’t trade on leverage using the margin account, you can still simply use the funds you have in your account for trading (e.g., $25,000) and use only the $25,000 for frequently buying and selling stocks as often as you want without being limited by the settlement date problem cash accounts have.
Conclusion
Margin trading and investing with borrowed funds can boost investment returns, but the leverage can also work against you. Investors typically don’t use margin-based buying power, while the margin account by itself is beneficial for portfolio rebalancing. Day traders use intraday-margin to leverage their positions by factor 4 and can diversify their investment activities.
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