Once you’ve mastered the basics of margin trading, you might want to learn how different trader and investor types use it. It can depend on your objectives, risk tolerance, and the products you trade.
Futures margin requires a lower percentage of initial margin versus Reg T, but with added leverage comes added risk
Learn how margin can be used for short-term financing
Investing or trading on margin at its most elementary level is akin to wrapping your hands around one of humankind’s oldest, most powerful tools: the lever. With margin, investors can borrow money to “lever up” their portfolios, gaining additional “muscle” to juice returns or diversify a portfolio. Margin can cut the opposite way, too, by amplifying losses.
Margin is borrowed money that’s used to buy stocks or other securities. In margin trading, a brokerage firm lends an account holder a portion (typically 30% to 50%) of the total purchase price, meaning an investor’s buying power goes up a commensurate amount. Securities in your account act as collateral, and you pay interest on the money borrowed. And since cash and securities in a margin account can act as collateral, some choose to use a margin account as a line of credit, with a flexible repayment plan.
In other words, once you move beyond the basics of margin, you'll see how it can be applied a variety of ways, depending on the type of investor or trader you are. Here are five broad categories of investor and trader types and how they might use margin.
Trading stocks on margin is typically governed by Regulation T (aka, Reg T), under which you can borrow up to 50% of the purchase price of securities. This is also known as “initial margin,” as some brokerages require a deposit greater than 50% of the purchase price. However, exchanges and brokerages can establish their own margin requirements as long as they are at least as restrictive as Reg T, according to the U.S. Securities and Exchange Commission.
For example, suppose you’d like to buy 1,000 shares of a stock currently trading at $20, or $20,000 worth, but you have only $10,000 available to invest. With margin, you can borrow an additional $10,000 and purchase those 1,000 shares.
If the stock rises from $20 to $25 a share (a gain of $5 per share, or $5,000), you’d have a 50% profit, because the gain is based on the $10 a share paid with cash, and excludes the $10 a share paid with funds borrowed from the broker. However, if the stock dropped to $15 a share, you’d have a loss of 50%—double what the loss would be if you paid for the stock entirely in cash. Also, you’ll likely be subject to a margin call, which means you must provide additional funds in order to maintain the required minimum.
How a Margin Call Works
Because margin magnifies both profits and losses, it’s possible to lose more than the initial amount used to purchase stock or other assets.
This magnifying effect can lead to a “margin call,” when losses exceed a limit set either by a broker or the broker’s regulating body. If this happens, you’ll hear from your broker.
The “maintenance” margin limit may be increased by the broker without prior notice, but often ranges from 30% to 40%, instead of the initial 50% required at the time of purchase.
But margin isn't limited to the long side. Investors with margin privileges can sell stocks short as well, with the aim of making money during, or hedging against, a market decline.
For traders and investors who buy and sell frequently, margin can be a handy ally when near-term potential opportunities pop up.
Individual investors and traders can apply for a regular margin account with as little as $2,000 but there are rules regarding what's called a pattern day trader, which is defined by FINRA as a margin account that executes four or more day trades or round trips within a rolling 5-business day period. Basically such accounts can only open and close a position within the same day 3 times within that time frame, or else the account will be flagged, and will then need a minimum equity balance of $25,000 or more.
In other words, if you have $25,000 in your account above and beyond any money needed to hold securities, if approved for margin, you have access to $100,000 of day-trading buying power. Still, keep in mind that if your equity drops below the $25,000 minimum for pattern day trading, you may be subject to a minimum day-trading equity call. Figure 1 shows how you can assess the impact of an individual trade before you make it.
FIGURE 1: ORDER CONFIRMATION TICKET. Before you send an order, you can assess the trade’s impact, i.e., how much margin the trade would require and your remaining buying power for both stocks and options. Image source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only.
Like the options market itself, trading on margin in options is a quite different, and often more complicated and risky, ball game.
Learn the benefits and risks of margin trading.
For “defined-risk” options strategies—such as long puts and calls, verticals, and iron condors—margin requirements are relatively straightforward. Margin functions like a cash account inside your “margin” account, meaning you simply need to put the cash up for the cost of long trades. Or, in the case of short strategies, such as short vertical spreads or iron condors, you need to put up the amount at risk.
Short vertical spreads, for example, would require the difference between the strike prices less the premium received on the sell side of the vertical. Remember, if or when you exercise such strategies, you need to follow the margin rules on the stock or underlying.
For option traders willing to step further out on the tightrope, there’s selling calls or puts “naked,” meaning with no hedging position in place to offset any losses.
The Naked Truth
Brokerages often set their own rules on “naked” selling of options. TD Ameritrade rules on the writing of uncovered puts and calls require an initial deposit and maintenance of the greatest of the following three formulas:
Much like margin trading in stocks, futures margin—also known unofficially as a performance bond—allows you to pay less than full price of a trade, enabling larger positions than could otherwise be made with your actual funds.
In futures markets, an investor or trader puts down a good-faith deposit with a broker called the initial margin requirement that ensures each party (buyer and seller) can meet their obligations as spelled out in the futures contract. Initial futures margin requirements vary by commodity and market volatility and are typically a small percentage—2% to 12%—of the notional value of the contract.
Much like other traditional loans, margin requires the posting of collateral to backstop the money you’re borrowing. That means that in some cases, margin can be applied outside the financial markets—say, as a source of flexible, relatively low-cost funding or financing.
However, it’s important to be cognizant of unique risks if margin is used for such purposes, as well as any tax implications. For example, interest expense would typically only be tax deductible if you use the proceeds of the debt to purchase investments, and those investments generate taxable net investment income.
Whichever investor or trader profile fits you, it’s important to remember that margin can be a useful tool if applied with prudent risk-management techniques. But it’s not to be abused or trifled with. Margin offers a number of potential benefits, but it comes with unique risks.
If you’re opening an account with TD Ameritrade, you can request approval for margin trading during the account opening process. If you’re already a TD Ameritrade client and you wish to add margin capabilities, log in to your account, select Client Services from the top menu, and then under My Profile, click General > Apply for Margin. Once approved, margin can be used on both tdameritrade.com and the thinkorswim® trading platform. Not all account holders will qualify.
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The risk of loss on an uncovered call option position is potentially unlimited since there is no limit to the price increase of the underlying security. The naked put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
The risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security. There is no guarantee the brokerage firm can continue to maintain a short position for an unlimited time period. Your position may be closed out by the firm without regard to your profit or loss.The risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security. There is no guarantee the brokerage firm can continue to maintain a short position for an unlimited time period. Your position may be closed out by the firm without regard to your profit or loss.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
Futures trading is speculative, and is not suitable for all investors. Please read the Risk Disclosure for Futures and Options prior to trading futures products. Futures trading services provided by TD Ameritrade Futures & Forex LLC. Trading privileges subject to review and approval. Not all clients will qualify.
Futures accounts are not protected by the Securities Investor Protection Corporation (SIPC).
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details. Please see our Web site or contact TD Ameritrade at 800-669-3900 for copies.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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