Trading on margin has a number of benefits for day traders. It allows you to open larger positions, turn over your capital more quickly, and short sell stocks. However, margin trading also entails risks that you need to be aware of.
We’ll cover everything you need to know about day trading on margin and explain how to make the most of margin trading.
What is Margin in Day Trading?
Trading on margin essentially means trading with borrowed money. Many brokers allow you to borrow cash for the purpose of trading. Trading on margin can allow you to magnify your profits, although it can also magnify your losses.
Like other types of loans, margin loans must be paid back with interest. When trading on margin, the cash in your account and the stocks that you purchase serve as collateral for the loan.
Margin Accounts vs. Cash Accounts
In order to trade on margin, you’ll need a margin account. This is distinct from a cash account, in which you can only trade using settled cash in your account.
Margin accounts require a minimum deposit of at least $2,000, although some brokers require more. When not actively trading on margin, margin and cash accounts work similarly.
Initial Margin Requirements
When trading on margin, you are required to post a minimum collateral for your loan. For stock trading in the US, the minimum initial margin requirement is 50%. That means that you can only fund half of a stock purchase with a margin loan—the other half must be funded with settled cash in your account. In other words, if you have $5,000 in your account, the most you can borrow to open a position is $5,000.
Many brokers have higher initial margin requirements. If a broker has a 60% margin requirement and you have $5,000 in cash, the most you can borrow to open a position is $3,333 ($5,000/0.60).
Benefits of Margin in Day Trading
There are several benefits to using margin for day trading.
Faster Capital Turnover
A margin account allows you to turn over your capital faster by eliminating the need to wait for trades to settle. When you close a position in a margin account, you can use proceeds from the trade to open another trade immediately.
That’s in contrast to cash accounts, which require you to wait two days for transactions to settle. Even if you have proceeds from a profitable trade, you can’t use that money to open another trade until the transaction settles.
Increased Buying Power
Since a margin account lets you open positions with borrowed money in addition to your own cash, you can open more and/or larger positions. This increased buying power, also known as leverage, enables you to take on more trades and increase the size of any trade.
It’s important to know how much leverage you can use. Day traders can typically access 4x leverage for intraday trading and 2x leverage for overnight trades. That is, if you have $5,000 in your account, you can open intraday positions worth up to $20,000 and overnight positions worth up to $10,000.
Short Selling
If you want to short sell stocks, you must have a margin account. Short selling involves borrowing shares instead of cash.
When short selling stocks, you must have an account balance equal to the value of the short trade plus 50%. So, if you want to open a $10,000 short position, you must have $15,000 in your margin account.
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Profit Potential
Day trading on margin can increase your potential profits. That’s because taking on a larger position translates to more money if a trade is successful. Having the ability to turn over capital in your account quickly also enables you to place more trades with the same amount of cash, enabling you to make potentially more profits.
Risks of Margin in Day Trading
Margin trading also comes with risks.
Loss Potential
Just as your potential profits are multiplied when trading on margin, so are your potential losses. A larger position size means that if a trade goes against you, you will lose more money.
It is even possible to lose more money than you started with in your account when trading on margin. This is most common in forex trading, in which brokers offer leverage up to 50x. Some brokers offer negative balance protection, meaning that the broker will not force you to repay losses that exceed your account balance.
Margin Calls
Once you have an open position funded on margin, your account balance (including the value of open positions) must remain above your broker’s margin maintenance requirement. This is a minimum of 25% for stock trading in the US.
Say you have $5,000 cash and use $5,000 margin to buy $10,000 worth of stock. If the value of the stock falls below $6,666 ($5,000/0.25), you’ll receive what’s known as a margin call.
When you receive a margin call, you must deposit additional cash within a few days to meet your margin maintenance requirement. Otherwise, your broker will liquidate your position to repay your loan. Having a position closed prematurely because of a margin call can result in large losses.
Potential for Reckless Trading
Trading with borrowed money can encourage reckless behavior. You need to be extremely disciplined to know when it’s appropriate to use margin and how to manage leveraged positions. It’s easy to chase large profits while trading on margin only to end up with huge losses.
How to Manage Margin Responsibly
We’ll cover a few tips to help you trade on margin effectively.
Use Margin as a Tool
Margin should be used as a specialized tool for trading rather than applied broadly to every trade.
You might want to use margin, for example, if you want to open multiple simultaneous positions and don’t have the capital to do so without margin. You might also use margin to double down on a winning trade with the aim of increasing your profit.
Keep in mind that margin loans carry interest rates. So, it’s only worthwhile to use margin if you expect the profit from a trade to be greater than the interest cost.
Be Aware of Your Buying Power
Buying power in day trading is a measure of the maximum amount of capital you can deploy during a single day. Your buying power will go down when you open positions and up when you close positions. It’s determined by your cash balance, the value of your positions, and your broker’s margin requirements.
The closer you get to using up all of your buying power, the more likely you are to incur a margin call. You should be aware of your remaining buyer power throughout the day and use it as a guide for how to size your positions.
Manage Risk Carefully
Leverage is a double-edged sword. If you borrow money from your brokerage to quadruple the size of a position, your potential profit goes up 4x, but your potential loss also increases 4x.
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This makes monitoring your risk-reward ratio more important than ever. If a trade has a 1:4 risk-reward ratio and you use 4x leverage, that produces an effective 4:16 risk-reward ratio—a favorable scenario for most traders. However, a 1:1.5 ratio with 4x leverage produces a 4:6 risk-reward ratio, which is much less favorable.
Use Stop Losses
Another way to manage your risk when day trading on margin is to use stop losses. Stop losses can limit the amount you stand to lose from a leveraged trade.
It’s a good idea to place stop losses above the level at which you’ll receive a margin call. That way, if a trade goes against you, you remain in control of when your position will be closed.
Be Careful Holding Overnight Positions
Be very cautious about holding positions overnight when trading on margin.
First, holding positions overnight exposes you to additional risk, and your potential losses from that risk are magnified.
Second, most brokers have higher margin requirements for overnight positions compared to intraday positions. You must have enough cash in your account to meet the higher margin requirement or else you’ll receive a margin call.
Conclusion: Day Trading On Margin
Day trading with margin involves borrowing money from your broker to open positions. Trading on margin can enable you to turn over capital more efficiently, increase your potential profits, and unlock short selling opportunities. However, leveraged positions also come with more risk. It’s important to be cautious when trading with margin.
