What Is Margin Trading?
Learn what margin is, what margin trading means, how trading on margin works, what a margin account is, and how margin is used in short selling, hedging, and options trading.
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Table of Contents:
1. What is margin?
Trading on margin means using borrowed funds to buy and sell assets. Part of this money is supplied by you, the trader, and an additional percent is supplied by the broker. For example, say you have 5k, and your broker allows 2x margin, you have 10k of buying power. It is important to note though, that you are not able to lose the bank's money. If a trade goes against you while trading on 2x margin, you are losing money 2x as fast on that 5k, if it drops too low, the broker will liquidate you in what is known as a margin call. Let’s do a small simulation, you buy 10k of a stock on 2x margin, meaning 5k of this is yours and 5k is borrowed from the bank. The stock goes up 10% and you sell. You’ve now made 1k - any borrowing and broker fees. (We will talk more about borrowing fees later) That’s awesome! You cash out that 1k and start again with 10k. This time the stock you buy drops 10%, you are now out 1k + borrowing and broker fees. Ok now you are net even, and we buy another stock. This one plummets, but you strongly believe it will go up in the long run. But margin accounts have a minimum equity threshold called the maintenance margin that must be maintained to avoid a margin call. For the sake of the example let’s set this at 2.5k. Well your ticker is still falling and you are down about 30% on the position, or 3k of our 5k, meaning you are now $500 under your accounts maintenance margin. Your broker sees this and demands that you either add an additional $500 of cash to the account to meet that threshold or they will liquidate your position and realize your 3k loss. Well you’ve had a pretty busy day at work, and by the time you check your account your broker has already liquidated your position, you’ve now realized a 3k loss, and on top of this you have to pay a small interest fee for borrowing the additional 5k plus broker fees. Not great right? Margin can be really dangerous to trade on and must be managed appropriately. In the remainder of this article we will talk about some different ways to utilize margin, and walk through a few numeric examples.
2. Basic ways to use margin
Short selling:
Short selling is one of the most common ways people use margin accounts. It is not possible to short sell without a margin account, as the process includes borrowing shares and then selling them on the market with hopes the stock will drop and you can buy back the shares you owe at a lower cost. Your money in the margin account acts as collateral for your borrowed shares. The Federal Reserve Board requires that 150% of the short sale value is available in the account as collateral to buy back the borrowed shares. This allows a 50% move above the borrow price before you will be liquidated and forced to cover your short (buy back the shares at that higher price). The New York Stock Exchange and the Nasdaq both require maintenance margin at 25% above the open position value of the shares, a lot of brokers will require even more at 30-40%. It is important to note that the maintenance margin value will fluctuate with the open position. If we assume that 25% maintenance margin requirement, if you borrow 10k worth of stock you must have 12.5k in the account to meet the maintenance margin requirements. If that trade goes against you, and the value of the borrowed shares is now 11k, the maintenance margin will go up with it to 12.75k. Failure to meet this will result in liquidation of the amount over the maintenance margin, so in this case $250 and you will be margin called and liquidated for that amount if you fail to meet the maintenance margin requirement. In the other direction, it works the same, if the share price drops like you want it to, the maintenance margin will drop with it, continuing with our example the price drops 10% and the 10k of shares you borrowed is now worth only 9k (meaning you could buy back those shares for 9k and make 1k profit) well your maintenance margin has dropped 10% as well and is now only 12.25k. This is called margin release.
Hedging:
Hedging positions is a great way to utilize margin, you can purchase a cheap hedge on high margin, and if you get margin called that means your primary position is now up more than you will be losing on your hedge assuming you do the hedging correctly. And if it goes the other way, well you’re on high margin so you’ve made a decent chunk back on the hedge. Another way people do this is with things that move against their holding. For example if they hold the s&p 500, they might hedge with a margin play on VIX (the volatility index) around major news events, such as fed rate cuts, tariff announcements, stuff like that. This is because if the s&p 500 drops quickly, usually VIX will spike quite aggressively, however it doesn’t really drop quickly from its all time lows, which it sits around pretty often.
Carry trades and Capital Efficiency:
Carry trading is when an investor borrows capital in a currency with a low interest rate (historically this has been the Japanese Yen) and they then convert it to a higher yielding currency such as the USD to buy assets like American bonds. They then profit off of the interest and use this to cover their borrowing fees + make a small profit. This is, of course, not without added risk. If the JPY strengthens significantly against the dollar, losses will be incurred when you transfer back from USD to JPY to cover your borrowed funds. This type of trading is best done in times of global political certainty and financial security, where the risk of large price fluctuations are low. If done correctly and at the right times, this allows for higher capital efficiency, you can use the same amount of USD to secure a significantly larger bond position.
Additional info: https://www.investopedia.com/carry-trade-definition-4682656
3. How is margin used in options trading?
Credit Spreads:
To start, with credit spreads the maintenance margin is calculated on the maximum possible loss, not the full position, this allows the use of more capital in your margin account than you would be able to use than if you were just purchasing a normal position. We go a lot more into credit spreads in this article here:
Covered Calls:
The benefits of margin with covered calls is that you can buy the shares on margin, meaning you can buy more shares, meaning you can sell more calls. You do have to be careful here though, if the stock drops you can get margin called even though the calls you sold will expire worthless because you are still holding the underlying asset. If the option contract you sold expires ITM you simply sell the shares at the strike price, repay your margin loan, and it executes like a normal trade.
CSPs:
The potential margin advantage to CSPs is that you don’t necessarily have to reserve the full amount of cash to make the trade, the required cash is calculated by the broker using a risk assessment formula. However, the broker is not saying that they trust you here, margin is variable and if the trade starts to go against you, it’s possible you get margin called before the strike is hit. Now let’s say the strike has been hit, and you’ve now been assigned, if you do not have sufficient cash you will be forced to buy those shares on margin, and you are now in a leveraged long stock position, and the margin rules around maintenance margin for a long position will apply. It is recommended that you only do this with small positions where you can tolerate a rapid drawdown on the stock should you get assigned.
Again if you would like to learn more about options trading, refer to our guide here: