With margin rates and leverage at a dangerous level, you can go from rich to broke in minutes. In the words of the most successful investor, 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.
At its 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 money you have in your account.
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.
Certainly, margin trading can be advantageous where you think your ROI would be much higher than the loan’s interest rate.
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Many day traders use margin (borrowed money) to access significant amounts of capital otherwise unavailable.
Let’s say you only have $10,000 cash in your trading account and want to buy Facebook shares. 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.
Key Takeaways
- Buying on margin is the act of borrowing money to buy securities
- Margin allows the trader to buy more securities than 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 use the securities in your account as collateral
- Brokers charge margin rates or interest on the loan
Margin Rates Example
The table below shows that most brokerages are sitting pretty from the cash they make off interest. Many 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.
TD Ameritrade Website
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 for 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
Margin Risks
Did you know that traders can lose more money than what they trade with? Yes, this is possible. Now, I must discuss 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 trading on margin makes losing more than 100% of your investment possible.
You’re theoretically on the hook for $20,000 in the example above. What happens if some unexpected event occurs, such as a global pandemic that wipes stock prices off the map?
It happened in March 2020 when FB saw its 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 for 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 monthly interest for the loan. Gross. I don’t use margin that much. It scares me to death.
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Calculating Margin Interest Rates
Back to Facebook. In this scenario, 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 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 result is a $50 charge to borrow $30,000 for ten days.
Alternative Way to Secure Margin
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.
Final Thoughts: Margin Rates
Margin can be a powerful tool if used carefully. Trading on margin without proper risk management strategies can and will put you into debt quickly.
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.
