Traders have three powerful words in their vocabulary—margin, leverage, and exposure. Understanding this trio’s potential risks and rewards is valuable as small market moves can add up to big trouble fast.
In fact, unexpected market movement can cause both large gains and losses in leveraged trading strategies when compared to unleveraged positions. Remember August 24, 2015? The Dow Jones Industrial Average ($DJI) plunged 1100 points, the CBOE Volatility Index (VIX) soared to 51 (it traded near 15 for much of 2015), and S&P 500 (SPX) futures dropped 7%.
A Page from the Rule Book
To purchase securities on margin, qualified traders who are approved for margin trading are required to sign a margin agreement so that they can borrow money from the broker to buy securities. They then use the securities as collateral. Borrowers must pay interest while this loan is outstanding.
The potential advantage of trading with margin is investors are only required to deposit a percentage of notional value of the securities. This financial leverage can help provide some flexibility in their portfolio, as well as potentially increase return on investment. The same thing happens on the risk side, in exchange for a potential increase in return, there is an increase in risk for the magnification of losses. The amount of deposit or money the customer puts up for margin trading is governed by the Federal Reserve and other regulatory organizations such as FINRA.
Brokers may require a higher percentage (margin requirement) based on the risk profile of the security or sector at any time without notification. Importantly, investors must understand that margin requirement is not always the maximum amount they can lose on the positions and the broker will require customers to keep a minimum account maintenance margin. If price fluctuations cause margin equity to fall below the house minimum, the broker can close out the customer’s positions, which means the customer can lose more funds than deposited in margin account. Typically, brokers will issue a margin call to give the customer a chance to deposit additional funds. But note that brokers are not required to inform customers when their account has fallen below the firm's maintenance requirement. When in a margin call, brokers may have the right to sell securities in a customer's margin account at any time without consulting the customer first. Under most margin agreements, even if the firm offers to give customers time to increase the equity in an account, it can sell their securities without waiting for the customer to meet the margin call.
Margin can also be used for futures and foreign exchange (forex) accounts. For this use, it’s referred to as a performance bond and is a deposit on the margin requirement determined by listing exchanges and upheld by the National Futures Association's margin handbook. In the case of futures and forex trading, margin is not borrowed money so customers don’t have to pay interest. Margin requirement can also be viewed as a good faith deposit on a position and can fluctuate with positions depending on underlying security movement. Margin requirement will come off when the positions are closed.
Now Let’s Talk Leverage
Leverage through margin allows traders to pay less than the full price of the trade, thereby putting on larger-sized trades than money in the account.This affords margin accounts more buying power. Generally, forex rules allow for the most leverage, followed by futures, then equities. Depending on the product, forex and futures leverage can be at 20-to-1 or even 50-to-1 compared to equities’ overnight margin of 4-to-1.
For example, E-mini S&P futures leverage is 19-to-1 based on notional value of the contract divided by margin requirement ($97,500/$5,060). Stock and exchange-traded fund (ETF) margin requirement is held at 30% x $19,585, or 4-to-1. This leverage allows customers trading futures in a $50,000 margin account to utilize 19-to-1 to control $950,000 of notional value vs stock, which would allow 4-to-1 trading and $200,000 worth of stock.
That’s why the third component—exposure—must be considered when using margin and leverage.
Know Your Exposure
Exposure is the risk of the investment and amount the trader stands to lose. Two risk measurements are used to calculate market exposure and financial risk, including expected price range (EPR) and point of no return (PNR).
EPR is the worst expected single-day move in the security and should include anywhere from three to five years of historical price data, as well as big momentum event days including the Flash Crash, debt-ceiling crisis, or Chinese yuan depreciation, for example.
EPR helps customers estimate if their portfolio has enough cushion to absorb tail risk or outlier moves.
Now, PNR takes into account losses from a single position (idiosyncratic) compared to the customer equity. In other words, at what percentage does the underlying price cause the account to become unsecured? The ideal risk plan: expected price range should always be higher than point of no return.
Trading is dynamic. Every day is a new day. What’s most important for self-directed traders is to make sure strategies, including the well-targeted use of margin and leverage, allow you to trade another day.
Get More Trading Leverage
Consider if applying for portfolio margin approval is right for you. You must meet minimum requirements and have at least $125K in total equity.*
Editor's note: This introductory article first ran in October 2015. Its teachings could prove valuable in a new trading year, as market participants look for potential opportunities to elevate their strategies.