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Trading with Margin - Respect it, but don't be afraid of it.
Until recently, 'margin' used to scare the bejesus out of me. I migrated to Commonstock from the likes of WSB, where every post not about $GME or $AMC was about being 'margin called' and seeking advice as to what to do.
But as I've learnt more about margin, and started utilising it myself, I've realised that it's not scary at all providing that it's shown the required amount of respect.
By respect, I mean at least learning the basics, how to calculate the various aspects of it, and also employing incredibly strict Risk Management rules and have the discipline to adhere to them.
I use Interactive Brokers (IBKR) and will use their nomenclature for my examples below. The wording may differ slightly for your broker but the concepts and governing regulations will remain the same.
It's a loan
And you have to pay it back in full regardless of the losses you incur. However, depending on your brokerage, the interest accrued on it is incredibly low (for example, IBKR's rate for me is 1.58%). Remember this part for later, please...
Regulation T (Reg T)
Reg T encompasses a lot of rules about the credit that brokerages can provide. The key takeaways for me are:
- You cannot 'day trade' (open and close the same position within the same trading session) with a Net Liquidating Value (NLV) of less than $25k.
- You must post at least 50%^ of the position price in cash - this is called the 'Initial Margin'.
- You must maintain a NLV of at least 25%^ of your portfolio value - this is the 'Maintenance Margin' (M/M).
^these are the Reg T minimum requirements. Some brokerages may require more.
Example of M/M violation resulting in a Margin Call
A cash balance of $500 gives me $1k of buying power - as per Reg T above, I have to post 50% of a position.
I then purchase $1k of stock. My Maintenance Margin is $250 (M/M is 25% of portfolio value as per Reg T)
YIKES! My portfolio value drops $200 and sits at $800! My M/M is now $200 (25% of portfolio) and my NLV is now $300 ($500 cash - $200 loss)
YIKES AGAIN! My portfolio value drops $200 again and sits at $600! My M/M is now $150 (25% of $600) but my NLV is only $100 ($500 cash - total loss of $400).
My Net Liquidating Value is now lower than my Maintenance Margin! I will now be subject to the dreaded 'Margin Call' and will either have to deposit additional cash to make up the short fall or my broker will start to liquidate my positions.
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And that is the crux of using margin. And the above example is exactly why I say Risk Management and unwavering discipline is required. Unmonitored losses can snowball at the best of times but can double when using margin (assuming you posted 50% and borrowed 50%).
As well as employing Stop Losses, I follow the below principles to mitigate my risk:
- Do not use margin to increase your position sizes. This will invalidate your Risk Management parameters.
- Use margin only to open positions that meet all of your normal entry criteria.
- Update a margin calculator at market close every day to ascertain your risk exposure (details later on).
- Build a buffer into your portfolio to ensure you will never be margin called; I use 20% i.e. I would have to lose 20% of my NLV to be margin called which isn't possible due to my Risk Management.
Special Memorandum Account (SMA)
Sometimes called a Special Margin Account and Special Miscellaneous Account, the SMA can be thought of as the cash available to you. As you only have to post 50% of the position opening in cash, your buying power is always twice the value of your SMA.
If the SMA can be thought of as the cash available, how does it differ? I'll start with the similarities for the sake of clarity:
- Increases/decreases with your cash deposits/withdrawals (remember this part as well, please!)
- Increases dollar-for-dollar with dividend payments (or decreases if you're short)
It differs in that:
- 50% of a security sale shows goes to the SMA (as you only paid 50% to purchase)
- it increases with unrealized gains but does not decrease with unrealized losses (or the reduction of unrealized gains).
You therefore have the ability to trade or invest your unrealized gains without closing your existing positions.
Do you remember what I asked you to remember?
Imagine it's my birthday and you want to buy me a gift (7th of July, btw). Your cash is tied up in positions, and all of them are winners so you want to let them run. But, because they're all winners, the SMA will be holding your unrealized gains - as the SMA represents cash available to you, you are able to withdraw this cash from your brokerage to your bank without closing any of your positions. This is a perfectly legitimate practice and many investors use this functionality instead of taking out traditional loans due to the comparatively low interest rates and the reduced paperwork.
In fact, the only restriction to using the SMA is that it cannot be negative upon market close (or face the Margin Call). Given that it only reduces with security purchases or withdrawals, you'll have no excuse!
!!!ONCE AGAIN!!! exercise strict Risk Management with unwavering discipline. Providing you treat margin with the same care, discipline, and respect that you would for any other trade then it can seriously augment your returns. Treat it with disregard or complacency however and it will ruin you.
P.S. I mentioned earlier about a margin calculator. You can download my personal calculator (correct as of market close 15th November) at https://we.tl/t-vOq6b3MY0P. If you have any questions on its use please feel free to get in touch!
@commonstock there aren't any tags applicable to this post :( Can we add a Tips/Advice/Learn from my Mistakes tag please?
we.tl
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