Understanding the basics of margin trading
You’ve probably heard some stories on both sides of the double-edged sword that is margin. Margin is generally used to leverage your cash and investments in order to increase your purchasing power. It allows you to borrow money from your broker in order to increase your buying power so that you can ultimately make larger trades than you would be able to in a cash account. Depending on your options trading level, you may be able to purchase securities on margin, sell stocks short, and trade a wide array of options strategies. Since margin represents a loan, you can think of securities you own in your cash account as the collateral for the loan. Margin may also help you enhance and diversify your trading strategy, as many actively traded options strategies can only be placed with a margin account.
Rules and regulations
To set up a margin account at E*TRADE, you’ll need to fund that account with at least $2,000 of margin equity. Margin equity consists of cash plus the market value of marginable securities in the account.
Because margin makes use of qualifying securities as collateral, you can borrow money to meet the initial margin requirements of a transaction. However, you will pay interest on that borrowed money and must eventually repay the loan. Finally, while a margin account offers a greater range of trading strategies due to the increased leverage, it also carries more risks than a cash account.
Because margin makes use of qualifying securities as collateral, you can borrow money to meet the initial margin requirements of a transaction.
What are the risks?
There is a possibility that you can lose more than your initial investment, including interest charges and commissions. If there’s a large enough drop in the value of your securities, and the equity in your account falls below E*TRADE’s requirements, you may have to provide additional funds to avoid the forced sale of those securities, or of other securities in your account. A request for additional funds due to a drop in the value of your margin portfolio is referred to as a margin call.
Tell me more about margin calls
A margin call occurs when the value of your account drops to a level where your broker believes he’s taking on more of your account’s risk than he’s comfortable with doing. Remember, you borrowed money in order to trade more than what your original funds allowed so you are responsible for your margin requirement. To resolve a margin call, you can deposit more funds into your account, or close out (liquidate) some positions in order to reduce your margin requirements. You won’t be able to open new positions until you’ve satisfied a margin call.
Alternatively, E*TRADE can sell securities in your account in order to cover your margin deficiency. You are also responsible for any shortfall in the account after these sales.
As a courtesy, E*TRADE may, whenever possible, make a best efforts attempt to notify you of margin calls, but they are not required to do so. Finally, note that there are no extensions of time to meet a maintenance margin call.
Using margin for stock trades
Suppose you want to buy 100 shares of XYZ stock currently trading at $60 per share. In a cash account, this trade would require you to put up the full cost of the trade, or $6,000. By contrast, a margin account allows you to borrow half of the cost of the trade from your broker. In this case, you would put up $3,000 (plus interest) to own $6,000 worth of stock. Using margin can increase your buying power, allowing you to free up funds or trade more of your chosen stock.
Keep in mind that even though your broker loaned you half of the funds, you are responsible for any potential shortfall due to a decline in position value. Furthermore, if the price of your stock falls enough, your broker will issue a margin call, asking you for more money.
Using margin on options trades
Things can get interesting when you use margin to make options trades. Let’s take a simple example using stock XYZ currently trading at $60 per share. Suppose you wanted to sell the 30-day, 60-strike put option currently trading for $4.
In a cash account, your requirement would be $6,000 less the $400 you received in option premium—a total of $5,600 (without taking any trading fees and commissions into account). Chances are you’d expect your requirement in a margin account to be somewhere around half that amount. However, margin on options can get fairly involved and often requires a matrix to figure things out, similar to this:
At E*TRADE, our margin tools calculate this requirement for you. We also include that requirement on the order ticket prior to the moment you place the trade. To sell one of the XYZ 60-strike puts for $4 in the example above, your total requirement would be $1,600. That’s $4,000 less than your cash account requirement on the same trade.