So, you’re thinking about using margin?

I mean let’s face it, artificial buying power to gain capital at a rate which would have been impossible with your fixed cash asset? Sounds pretty tempting right?

How does it all work? Let’s look at two examples. A 1:1 margin account, and a 1:4 margin account.

First, please understand that there are brokerage accounts called “Cash Accounts.” They’re simple, what ever cash you upload into your account equates the buying power you have to take a position in the stock market. So, the only amount you can lose, is the cash you uploaded.

How a margin account differs, is that based on the margin ratio, you can increase your buying power “on margin” – meaning using the brokerage’s loaned money to trade and invest.

So, let’s say you injected $10, 000 into a margin account with a 1:1 ratio. 

This means that you have an additional, $10, 000 available on margin (credit) to buy and sell stock with. What just happened to your buying power? You doubled it. You can buy $20, 000 worth of stock.

This is all fine and dandy when you make money. How so?

Let’s say you took a $10, 000 position on a stock that you believe was going up. You were so delusional and risk averse that you decided to fully leverage the margin available on this position, and took the additional $10, 000 from your brokerage as well in this position. You have effectively taken a $20, 000 position in the stock. $10k of your own money, and $10k of the brokerage’s money. The stock moves up the 10% you anticipated, and you now sell the complete position. 

Of the $10k which is yours, you get to keep $1000 (10% return).

Of the $10k which is the brokers margin, you get to keep $1000 (10% return) less the margin rate. Which is the interest rate charged to lend you the margin. Let’s assume 2% margin rate, means you get to keep $800. 

What happened? You invested $10k of your own money, and you made 18% return, where had you not used margin, you’d only make 10% return. This is the power of margin and it can be a fantastic thing if you manage your risk accordingly.

How can this turn badly?

Let’s assume you take the same $10k trade with the $10k margin, and the stock retraces 10%. You lose $1000 on your cash position, putting you at $9000 buying power remaining. On top of that, you lost $1000 of the brokerage margin which you owe, placing you at $8000 cash. On top of that, you also owe the 2% margin rate placing you at $7800. 

Let’s examine the 1:4 margin account.

Same scenario, $10k account with $40k margin for a total of $50k buying power.

You take a $10k position and margin out $40k for a total of a $50k position in a stock. The stock moves 10% upwards, you sell, and all is well.

Of the $10k cash position which is yours you keep $1000 profit.
Of the $40k margin position, which is the brokerage’s, you keep $4000 profit less the 2% margin rate of $800 for a total of $3200.

$3200 + $1000 and you made $4200 on a $10, 000 cash position using $40k additional margin.

The opposite example gets outright disgusting, and this is where you would absolutely get what’s called a margin call.

This is a phone call you never want to get, as the broker is calling to tell you that the amount of risk you’ve introduced into the position requires you to actually deposit money into the account to continue using the margin. Otherwise, if you’re unable to inject more cash into the brokerage, the broker will begin selling your current position to recuperate as much of the margin they have lent you, and whatever they were unable to recuperate, you now owe. Plus, interest and late penalty fees that the individual broker policies may have. They can essentially bankrupt you in one trade. Implosion to the max as they say.

How can you increase buying power but not invite disaster?

Consider the use of the 20% margin rule. In that whatever you have in cash buying power, never take more than 20% of it out in the form of margin. I personally don’t like this approach at all, but it is better than leveraging your entire cash position in the form of margin. Afterwards I will expose how I prefer to increase buying power. Anyway - 

If you have a $10k account? Never use more than $2k in margin. This allows you a $12k buying power. 

Normally I don’t take more than 30% of my account size (read about my 1/3rd factor explained here).

Let’s assume a $10, 000 account. I would never take more than $3000 in any given trade. Now, even though I have an additional $10k in margin available based on my $10k cash account, I would only take 20% of that availability equating $2000 dollars in margin. This would allow me to take a $5000 ($3k cash + $2k margin) position on a stock. If the stock goes up, there’s no questions asked, I win. However, let’s examine a scenario where the stock price plummets 50% and I’m for some reason still in it. 

What’s the worst-case scenario?

Price Entry: $1.00/shares
Buying power: $5000 ($3k capital + $2k margin)
Number of shares to purchase: 5000 shares.
Margin Rate: 2%

Stock crashes to a price: $0.50/share and I sell.
Closing balance: $2500 ($1500 capital + $1000 margin)
Margin rate: 2% of $2000 is $40.
What margin did the bank borrow me: $2000
Calculation: $2000 loaned - $1000 remaining + $40 margin rate = $1040 payable to broker

Remaining balance: $10, 000 – 1500 (capital loss) - $1040 to broker = $7,460

Instead of loaning 20% margin on your $10k allowance one can consider loaning out 20% on the position. So, in the case of a $3000 position, you loan $600 margin. It reduces your risk significantly, and also allows you to work with a 20% stronger buying power. In the instance of the $2000 margin, we were working with a 40% margin as we were effectively taking a $5000 position with $2000 margin.

My preferred way in using debt to trade:

The other way I actually prefer is that if I am going to work with the bank’s capital, I will opt to secure an investment loan at prime against my cash balance and use that to increase artificial buying power.

For example, I have a $100k brokerage account, and I want 20% margin. I will loan $20k at prime and continually pay the interest, and work with my $120k account. And at no point will I let the $120k brokerage account go below a balance of $20k, as that is my secured asset against the debenture. In fact, in certain institutions control of your account is given to your brokerage to sell your portfolio so that the $20k is never tampered with. Certain margin accounts have this feature too, but they will deplete at a much faster rate than if a $20k loan was simply used and uploaded in the form of “cash” into the brokerage account. 

There are multiple ways to skin this cat.

While margin can be a great way to grow your account, it actually introduces a faster rate to deplete your account, especially as a beginner. So, we do not work with margin. We take cash positions, and if we want to increase our buying power, we work with the financial institutions to actually use investment loan products which organically increase our buying power against a fixed cash asset, so we are never in a negative equity position with the bank. We like having a good relationship with the banks. This is very important. Learn more about how to intelligently use the bank’s leverage to generate capital here.