Understanding the basics of margin trading
Margin is generally used to leverage securities you already own to buy additional securities. Margin allows you to borrow money from your broker-dealer in order to increase your buying power. Since margin is a loan, you can think of securities you own in your cash account as the collateral for the loan.
Rules and regulations
To open a margin account, you’ll need to fund that account with at least $2,000 of equity. Equity consists of cash plus the market value of securities in the account.
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.
What are the risks?
There is a possibility that you could 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 below the minimum level established by your broker-dealer. To resolve a margin call, you can either deposit more funds into your account or close out (liquidate) some positions in order to reduce your margin requirements.
Alternatively, E*TRADE can sell securities in your account in order to cover your margin deficiency at any time without prior notice. You are also responsible for any shortfall in the account after these sales.
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 to own $6,000 worth of stock. This activity would also be subject to applicable fees, commissions, and interest. 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.
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, using margin on options can get fairly involved and often requires a matrix like the one below to calculate the requirement:
At E*TRADE, our margin tools can help you calculate applicable requirements. We also include the 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.